Pecking order theory

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In corporate finance, the pecking order theory argues that financing costs increase with asymmetric information.

Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their financing sources, first prefer internal financing, and then debt, which ultimately raises equity as a "last resort". Therefore: internal financing is used first; when it is exhausted, then the debt is issued; and when it no longer makes sense to issue more debt, equity is issued. This theory states that businesses adhere to the hierarchy of financing sources and prefer internal funding when available, and debt is preferred over equity if external financing is needed (equity means issuing shares meaning 'bringing external ownership' into the company). Thus, the form of debt the firm chooses can act as a signal of its need for external finance.

The pecking order theory was popularized by Myers and Majluf (1984) where they argued that equity is an unfavorable way to raise capital because when managers (who are assumed to know better about the real condition of firms than investors) issue new equities, investors believe that managers thinking that the company is overvalued and managers take advantage of this overvaluation. As a result, investors will place a lower value for the issuance of new equities.

Video Pecking order theory

Histori

The pecking order theory was first proposed by Donaldson in 1961 and modified by Stewart C. Myers and Nicolas Majluf in 1984. It states that companies prioritize their funding sources (from internal to equity financing) in accordance with financing costs, preferring to increase equity as a means of financing of last resort. Therefore, internal funds are used first, and when it is discharged, debt is issued, and when it does not make sense to issue more debt, equity is issued.

Maps Pecking order theory

Theory

Pecking order theory begins with asymmetric information because managers know more about the prospects, risks, and value of their companies than outside investors. Asymmetric information influences the choice between internal and external financing and between debt or equity issues. Therefore, there is a pecking order for financing new projects.

Asymmetric information supports the issue of debt over equity because debt issues signify that the board believes that profitable investment and stock prices are currently under-valued (whether stock prices are too high, equity issues will be favored). The issue of equity will signal a lack of trust in the board and that they feel the stock price is too valuable. The issue of equity will cause a decline in stock prices. This however does not apply to high-tech industries where equity issues are preferred because of the high cost of debt problems due to intangible assets.

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Evidence

Pecking order theory testing has not been able to show that it is of first-order interest in determining the capital structure of the firm. However, some writers have found that there are instances where it is a good estimate of reality. On the one hand, Fama and France,. Zeidan, Galil and Shapir (2018) documented that private owners in Brazil followed the pecking order theory, and also Myers and Shyam-Sunder found that some data features were better explained by a power sequence than by the trade-off theory. Goyal and Frank shows, among other things, that the pecking order theory fails where it should hold, that is for small companies where asymmetry information may be an important issue.

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Profitability and debt ratio

The pecking order theory explains the inverse relationship between profitability and debt ratios:

1. The company prefers internal financing.
2. They adjust their target dividend payout ratio to their investment opportunities, while trying to avoid a sudden change in dividends.
3. The sticky dividend policy, plus the unexpected fluctuations in profits and investment opportunities, means that internally generated cash flow is sometimes more than capital expenditure and at other times less. If more, the company pays the debt or invests in the securities. If it is lacking, the first firm withdraws cash balances or sells securities, rather than reducing dividends.
4. If external financing is required, the company issues the safest security first. That is, they start with debt, then maybe hybrid securities like convertible bonds, then maybe equity as a last resort. In addition, the least issuance costs for internal funds, low for debt and highest for equity. There is also a negative signal to the stock market associated with equity issuance, a positive signal associated with debt.

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See also

• Capital structure substitution theory
• Corporate financing
• Capital cost
• Market timing hypothesis

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References

Source of the article : Wikipedia