Pecking & Trade Off Theory

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Analyse the pecking order and the trade-off theories of capital structure and assess the extent to which these are supported by the empirical evidence.

Pecking Order - Introduction

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.

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....
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