The pecking order theory ( Donaldson 1961) of capital structure is among the most influential theories of corporate leverage. The pecking order theory is based on different of information between corporate insiders and the market. According to Myers (1984), due to adverse selection, firm prefer internal to external finance. If internal finance proves insufficient, bank borrowings and corporate bonds are the preferred source of external source of finance.
After exhausting both of these possibilities, the final and least preferred source of finance is issuing new equity.. These ideas were refined into a key testable prediction by Shyam-Sunder and Myers(1999). The financing deficit should normally be matched dollar-for-dollar by change in corporate debt. As result, it firms follow the pecking order, then in a regression of net debt issues on the financing deficit, a slope coefficient of one is observed.
Theory The pecking order theory is from Myers(1984) and Myers and Majluf(1984). Since it is well know, we can be brief. Suppose that there are three sources of funding available to firms: Retained earnings have no adverse selection problem. Equity is subject to serious adverse selection problems while debt has only a minor adverse selection problem. From the point of view of an outside investor, equity is strictly riskier that debt. Both outside investor will demand a higher rate of return on equity that on debt.
From the perspective of those inside the firm, retained earnings are a better source of funds all projects using retained earnings if possible. If there is an inadequate amount of retained earnings, then debt financing will be used will match the net debt issues.The pecking order theory is more concerned with the shorter run, tactical issue of raising external funds to finance investment. So this theory is very useful ways to understanding corporate use of debt.
For example, it is probably the case that firms have long-run, target capital structures, but also probably true that they will deviate from those long – run targets as needed to avoid issuing new equity. Myers (1984) suggested that the order of Preference stemmed from the existence of asymmetry of information between the company and the capital markets.Myers calls the pecking order hypothesis of financing which says; finance new investment first internally, then with low risk debt and then finally with equity. Matures firms, in particular, are therefore likely to maintain financial slack to enable them take advantage of profitable investment opportunities. Pecking order theory suggest that companies rather that seeking an optimal capital structure prefer retained earning to external founds and prefer new debt to new enquiry.
The pecking order theory indicates that firms prefer internal financing (retained earnings) to external financing (new security issues). This preference for internal financing is based two consideration. First, because of flotation costs of new financing avoids the discipline and monitoring that occurs when new securities are sold publicly. Also, according to the pecking order theory, dividends are “sticky”, that is, many firms are reluctant to make major changes in dividend payments and only gradually adjust dividend payout ratios to reflect their investment opportunities and thereby avoid the issuance of new securities.Managers cannot use special knowledge of their firm to determine if this type of debt is mispriced, because the price of riskless debt is determined solely by the marketwide interest rate.
However, in reality corporate debt has the possibility of default. Thus, just as managers have a tendency to issue equity when they think it is overvalued, managers also have a tendency to issue debt when they thinks it is overvalued. When would managers view their debt as overvalued? Probably in the same situations when they think their equity is overvalued. For example, if the public thinks that the firm’s prospects are rosy but the managers see trouble ahead, these managers would view their debt-as well as their equity-as being overvalued. That is, the public might see the debt as nearly risk- free, whereas the mangers see a strong possibility of default.
If external financing is required, the “safest” securities, namely debt, are issued first. Although investors fear mispricing of both debt and equity, the fear is much greater for equity. Corporate debt still relatively little risk compared to equity because, if financial distress is avoided, investors receive a fixed return.. Thus, the pecking order theory implies that, if outside financing required, debt should be issued before equity. Only when the firm’s debt capacity is reached should the firm consider equity.
Also, the stock market tends to react negatively to announcements of new common stock offerings, whereas debt security announcement tend to have little impact on stock prices. As a additional external financing is needed, the firm will work down the pecking order – from safe to more risky debt, then possibly to convertible debt, and finally to common equity as a last resort.Empirical Specification A recent strand of the empirical literature attempts to design a test for the pecking order (Shyam-Sunder and Myers, 1999; Frank and Goyal, 2003; Watson and Wilson,2002;Lemmon and Zender,2003). Shyam-Sunder and Myers(1999) develop a smile model for a strict version of the pecking order hypothesis, which holds that when the firms needs external finance, it will only issue debt, not equity. After and IPO, equity financing is used under extreme circumstances, especially when the cost of financial distress is high.
Evidence of the pecking order Graham and Harvey (2001) undertook a major survey of attitudes of senior managers in a large sample of larger US business in 1999. Graham and Harvey found that managers’ behavior seemed to be consistent with pecking order theory. They found that business are reluctant to issue new shares where it is perceived that existing shares are undervalued, and this is an important consideration in share issue decision. They report that senior managers in more than two thirds of business believe that their shares are undervalued.
This is consistent with the pecking order theory.Graham and Harvey also found that most businesses had a target ratio, which is inconsistent with the pecking order theory. Frank and Goyal (2003) tested the pecking order theory on the basis of what a broad cross-section of US business actually did (rather than what managers said that they felt) during the period 1980 to 1998. They found that the business behaved exactly in line with the trade-off theory and not as they would have been predicted to behave had the pecking order theory been validTrade-off - IntroductionKrauz and Litenzberger (1973) introduced the trade-off theory, which basically states a firm can choose a level of debt an equity financing by balancing the cost and benefits of each, especially since debt payments are tax deductible.
The trade-off theory states a preference towards financing with debt partly due to this tax shield contra the bankruptcy cost. The marginal advantages of further increasing one’s debt will, however, decline as debt increases, as marginal cost of debt goes up with the higher level of risk which follows further borrowing. For an optimizing firm wanting to have as high as possible overall value, it will focus its attention on the trade-off when choosing its mix between debt an equity to use for its financial needs.Theory The trade-off theory of capital structure is based on balancing the expected costs from financial distress against the tax benefits of debt service payments.
Unlike the Modigliani and Miller proposition of no optimal capital structure, or a structure with almost all debt when the tax shield is considered, static trade –off theory puts forth an optimal capital structure with an optimal proportion of debt. Optimal debt usage is found at the point where any additional debt would cause the cost of financial distress to increase by a greater amount than the benefits of the additional tax shield.The optimal capital structure depends on the company’s business risk, combined with its tax situation , corporate governance, and financial accounting information transparency, among other factors. However, what we can say, based on this theory, is that a company should consider a number of factors, including its business risk and the possible costs of financial distress, in determining its capital structure. A company’s management uses these tools to decide the level of debt appropriate for the company.
The tax benefit from the deductibility of the interest expense of debt must be balanced against the risk associated with the use of debt. The extent of financial leverage used should thus depend on owners’ and management’s appetites for risk, as well as the stability of the company’s business environment. As the proportion of debt in a business rises, the costs of both debt an enquiry are likely to rise to offset the higher risks associated with higher levels of debt. Firms want to avoid the direct and indirect cost associated financial difficulties, they will choose lover level of debt, even though that reduces the amount of tax saving they will get.The level of gearing is therefore a trade-off between the benefits of debt i.
e the tax saving and the potential costs associated with financial distress. And implication of this trade-off theory is that there might be an optimal gearing ratio at which the present value of tax shield equal to the present value of bankruptcy cost. However, there is as yet no model that can identify this optimal structure.ConclusionsThe pecking order theory is tested on a broad cross-section of publicly traded American firms over the period 1971 to 1998. In contrast to what often suggested, internal financing is not sufficient to cover investment spending on average.
External financing is heavily used. Debt financing does not dominate equity financing in magnitude. Net equity issues track the financing deficit quite closely, while net debt does not do so. The current portion of long-term debt is not treated as part of the financing deficit.
The pecking order theory is a competitor to the conventional leverage regressions. It is thus important to examine the relative of the two approaches.In specifications that nest the two approaches, the financing deficit adds a small amount of extra explanatory power. But the financing deficit does not challenge the role of the conventional leverage factors.
Summarize that pecking order theory seemingly work best for large, mature firms which have access to public bond markets. Also those firms rarely issue new equity, they can often finance within the firm and will turn to the debt market should there be extra need for more financing.Brealey and Mayres (2006) summarize that the trade-off theory is especially helpful in explaining different capital structures across industries. Industries which are considered relatively safe and those of high ratios of tangible assets show higher debt ratios ,while riskier industries with a of intangible assets and valuations depending on growth opportunities show lover debt ratios. Trade-off theory implies there should be a negative relationship between interest rates and leverage.
As the cost debt goes up, so will the risk of bankruptcy. Firms often keep an interest coverage goal in order to control this risk and therefore an increase in interest payments will force firms to lower its debt level.Referenceshttp://www.britishairways.com/health/docs/before/airtravel_guide.pdf
