Pecking Order Theory of Capital Structure

Contents

Abstract 2

Introduction 3

Overview of the Theory 4

The Theory 5

Pecking order theory: Illustration 7

Rules of pecking order theory 8

Pecking order theory vs. Trade off theory 10

Limitations of Pecking order theory 12

Conclusion 13

References 14

Abstract

The pecking order theory of capital structure is among the most influential theories of corporate leverage. According to Myers (1984), due to adverse selection, firms prefer internal to external financing. When outside funds are necessary, firms prefer debt to equity because of lower information costs associated with debt issues. Equity is rarely issued. These ideas were refined into a key testable prediction by Shyam-Sunder and Myers. The financing deficit should normally be matched dollar-for-dollar by a change in corporate debt. As a result, if firms follow the pecking order, then in a regression of net debt issues on the financing deficit, a slope co-efficient of one is observed.

Introduction

In modern business world money is not a problem at all. The entire finance course discusses the several financial mechanism of raising capital. Pecking order theory is one of the world wide popular theories of financing. Studying capital structure is an important component of any typical introductory finance course. The topic provides closure to a representative unit about capital budgeting and cost of capital. This theory determines how best to finance capital projects that will hopefully enhance the value of their firms. Such a unit also amplifies the importance of, and provides a stronger theoretical foundation. The traditional approach found in most introductory textbooks is to present Modigliani and Miller's capital structure irrelevance hypothesis (Modigliani & Miller, 1958) and then build in the effects of taxes, financial distress, and agency costs until the "mainstream" model of optimal capital structure emerges. It is a tidy approach (often referred to as the "Trade-Off Model") that is easily understood under the basic underlying tenet of optimizing value - and thus shareholder wealth - by choosing a capital structure combination which elicits the lowest possible cost of capital for the firm. Once the firm finds this optimal combination of financing sources the assumption is that every new dollar of financing is raised in the same proportions of debt and equity financing.

Overview of the Theory

The pecking order theory of capital structure is among the most influential theories of corporate leverage. According to Myers (1984), due to adverse selection, firms prefer internal to external finance. When outside funds are necessary, firms prefer debt to equity because of lower information costs associated with debt issues. Equity is rarely issued. The pecking order is a competitor to other mainstream empirical models of corporate leverage. According to the pecking order theory, financing behavior is driven by adverse selection costs. The theory should perform best among firms that face particularly severe adverse selection problems. Small high-growth firms are often thought of as firms with large information asymmetries. The pecking order theory makes predictions about the maturity and priority structure of debt. Securities with the lowest information costs should be issued first, before the firm issues securities with higher information costs. Internal funds incur no flotation costs and require no additional disclosure of proprietary financial information that could lead to more severe market discipline and a possible loss of competitive advantage. Pecking order theory of capital structure states that firms have a preferred hierarchy for financing decisions. The highest preference is to use internal financing (retained earnings and the effects of depreciation) before resorting to any form of external funds. If a firm must use external funds, the preference is to use the following order of financing sources: debt, convertible securities, preferred stock, and common stock. This order reflects the motivations of the financial manager to retain control of the firm, reduce the agency costs of equity, and avoid the seemingly inevitable negative market reaction to an announcement of a new equity issue.

The Theory

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. So the pecking order theory is from Myers (1984) and Myers and Majluf (1984). Implicit in pecking order theory are two key assumptions about financial managers. The first of these is asymmetric information, or the likelihood that a firm's managers know more about the company's current earnings and future growth opportunities than do outside investors. There is a strong desire to keep such information proprietary. The use of internal funds precludes managers from having to make public disclosures about the company's investment opportunities and potential profits to be realized from investing in them. The second assumption is that managers will act in the best interests of the company's existing shareholders. The managers may even forgo a positive-NPV project if it would require the issue of new equity, since this would give much of the project's value to new shareholders at the expense of the old (Myers & Majluf, 1984). The theory 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.

So the theory can be presented as:

 Firms prefer internal financing.

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