Pecking order theory

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Jump to: navigation, search In the theory of firm's capital structure and financing decisions, the pecking order theory or pecking order model was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers and Nicolas Majluf in 1984 [1]. It states that companies prioritize their sources of financing (from internal financing to equity) according to the principle of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued. Pecking order theory starts with asymmetric information as managers know more about their companies prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. There therefore exists a pecking order for the financing of new projects. Asymmetric information favours the issue of debt over equity as the issue of debt signals the boards confidence that an investment is profitable and that the current stock price is undervalued (were stock price over-valued, the issue of equity would be favoured). The issue of equity would signal a lack of confidence in the board and that they feel the share price is over-valued. An issue of equity would therefore lead to a drop in share price. This does not however apply to high-tech industries where the issue of equity is preferable due to the high cost of debt issue as assets are intangible [2]

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1 Evidence 2 Profitability and debt ratios 3 See also 4 References

[edit] Evidence
Tests of the pecking order theory have not been able to show that it is of first-order importance in determining a firm's capital structure. However, several authors have found that there are instances where it is a good approximation of reality. On the one hand, Fama and French[3], and also Myers and Shyam-Sunder[4] find that some features of the data are better explained by the Pecking Order than by the trade-off theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry is presumably an important problem. [5]

[edit] Profitability and debt ratios

The pecking order theory explains the inverse relationship between profitability and debt ratios: 1. Firms prefer internal financing.

2. They adapt their target dividend payout ratios to their investment opportunities, while

trying to avoid sudden changes in dividends. 3. Sticky dividend policies, plus unpredictable fluctuations in profits and investment opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the firm pays off the debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities, rather than reduce dividends.
4. If external financing is required, firms issue the safest security first. That is, they start

with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In addition, issue costs are least for internal funds, low for debt and highest for equity. There is also the negative signaling to the stock market associated with issuing equity, positive signaling associated with debt.[6]

Trade-off theory of capital structure

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As the Debt equity ratio (ie leverage) increases, there is a trade-off between the interest tax shield and bankruptcy, causing an optimum capital structure, D/E* The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger[1] who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the literature is provided by Frank and Goyal.[2] An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc). The

marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

[edit] Evidence
The empirical relevance of the trade-off theory has often been questioned. Miller[3] for example compared this balancing as akin to the balance between horse and rabbit content in a stew of one horse and one rabbit. Taxes are large and they are sure, while bankruptcy is rare and, according to Miller, it has low dead-weight costs. Accordingly he suggested that if the trade-off theory were true, then firms ought to have much higher debt levels than we observe in reality. Myers[4] was a particularly fierce critic in his Presidential address to the American Finance Association meetings in which he proposed what he called "the pecking order theory". Fama and French [5] criticized both the trade-off theory and the pecking order theory in different ways. Welch has argued that firms do not undo the impact of stock price shocks as they should under the basic trade-off theory and so the mechanical change in asset prices that makes up for most of the variation in capital structure.[6] Despite such criticisms, the trade-off theory remains the dominant theory of corporate capital structure as taught in the main corporate finance textbooks. Dynamic version of the model generally seem to offer enough flexibility in matching the data so, contrary to Miller's[3] verbal argument, dynamic trade-off models are very hard to reject empirically. Definition of Signalling theory - Finance dictionary
Signalling theory ((See Chapters 23 and 36 of the Vernimmen)) Signalling theory is based on the assumption that information is not equally available to all parties at the same time, and that information asymmetry is the rule. Information asymmetries (see also asymmetry issuer/investor) can result in very low valuations or a sub-optimum investment policy. Signalling theory states that corporate financial decisions are signals sent by the company's managers to investors in order to shake up these asymmetries. These signals are the cornerstone of financial communications policy.

Signalling theory ((See Chapters 23 and 36 of the Vernimmen)) Signalling theory is based on the assumption that information is not equally available to all parties at the same time, and that information asymmetry is the rule. Information asymmetries (see also asymmetry issuer/investor) can result in very low valuations or a sub-optimum investment policy. Signalling theory states that corporate financial decisions are signals sent by the company's managers to investors in order to shake up these asymmetries. These signals are the cornerstone of financial communications policy.
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agency theory
Definition
A theory explaining the relationship between principals, such as a shareholders, and agents, such as a company's executives. In this relationship the principal delegates or hires an agent to perform work. The theory attempts to deal with two specific problems: first, that the goals of the principal and agent are not in conflict (agency problem), and second, that the principal and agent reconcile different tolerances for risk.

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