Critically assess the Pecking Order Theory of Capital Structure

Finding the perfect capital structure in terms of risk and reward can ensure a company meets shareholder expectations and protects a firm in times of recession. Capital structure refers to how a business puts its money to “work”. The two forms of capital structure are equity capital and debt capital. Both have their benefits and limitations. Striking that perfect balance between the two can mean the difference between thriving versus trying to survive.

When firms go public, their capital structure reflects a number of factors, including market-to-book, asset tangibility, size, and research and development intensity. As firms age, the cross-section of leverage is more and more explained by past financing opportunities, as determined by the market-to-book ratio, and past opportunities to accumulate retained earnings, as determined by profitability. Historical within-firm variation in market-to-book, not current cross-firm variation, is more

Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that

The company is financed both by equity and debt, there is no perfect combination of the debt and equity, and still finance managers believe that every firm has an optimized value of creation of funds through both the sources which capitalize on shareholders fund as well as the financial value added by the firm.

Nevertheless, firms have used leverage even before corporate taxes have been introduced (Maris and Elayan, 1990). This implies the existence of some market imperfections, which benefit the use of debt financing, thus enable a trade-off of the cost and benefits of debt resulting in an optimal capital structure, where marginal cost equal marginal benefits.

According to Hall et al., (2000) and Schmid (2001) (as cited in Paul et al., 2007, p. 10), they found out that at the stage of development, businesses are informationally opaque which means the information is not transparent to public. At the same time, the start-up firm’s assets are often intangible and knowledge-based. So, if compared to the opportunities in the public companies, investors in the start-up work with less historic performance data on which investment judgements can be based. Again, the researches mentioned that the firms prefer internal to external finance when the external funds are necessary. It can be clearly understood that the firm prefer debt to equity finance. This hierarchy stems from information asymmetry between managers and investors with the results that, in attempting to raise external capital, investors will face an adverse selection problem and demand a premium that raises the required rate of return on external capital. At this point, the firms are definitely better off with the internally generated funds. The overall impact of information asymmetry is that external financing may carry a substantial investment premium (Jovanovic, 1982; Storey, 1994 as cited in Paul et al., 2007, p. 11). So, debt is preferable to equity finance due to the less risky

In a company there are 3 ways to generate capital, which can be generated internally through the sales of assets or from profitable operations. Another was is from the issues of shares to potential investors who are willing to contribute to the company and lastly borrowing from creditors. This report is looking into legal ramifications for a company deciding to finance it activities through equity (share capital) or debt (loan capital).

The Modigliani-Miller theorem is the basis for modern thinking on capital structure. The basic theorem that, under certain market process (the classical random walk), in the absence of taxes, bankruptcy costs and asymmetric information, i.e., in an efficient market, the value of a company is not affected by the way the company is financed. No matter whether the capital of the company is obtained with the issue of shares or debt. No matter what the dividend policy of the company. Therefore, the Modigliani-Miller theorem is also often called The Principle of irrelevance of capital structure. It is the emergence of corporate taxes that undo the irrelevance in the structure of financing and the cost of debt is reduced because it is a paid before income tax expense.

A firm can choose a mix of three modes of financing i.e. issuing shares, borrowing from the market and use of retained earnings. The ratio of this mix of funds purely depends on the firm and known as optimal capital structure of the firm. This leads to the different capital structure theories. These theories explain their

For firms whose cash reserves appear to greatly exceed their needs in the foreseeable future, an additional dollar of cash reserves is more likely to be distributed to equity holders through dividends and/or stock repurchases. However, because of the “dividend tax,” only the fraction (1 − τ d ) ends up in the hands of shareholders.3 As such, the marginal value of cash is reduced to (1 − τ d ), which can be significantly below $1. Additionally, if firms use their cash to pay down debt or other liabilities, a small increase in cash reserves partially goes to increasing debt value, not solely to increasing equity value. Thus, the equity market will place a lower value on an additional dollar of cash for high leverage firms relative to the marginal value of cash for a firm with little debt. In contrast, for those firms that need to raise cash from external markets because they have value-enhancing investment opportunities but their internal funds are low, the marginal value of cash should be higher than $1, with the exact amount depending upon the transactions costs (direct or otherwise) that are incurred by accessing the capital markets. Therefore, the marginal value of cash should decline as cash holdings increase because as the cash position of the firm improves, firms become more likely to distribute funds and less likely to raise cash. We also argue that for firms that face greater financing

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.

Information asymmetry plays an important role in corporate finance. Discuss in the light of signaling hypothesis of dividend policy and debt financing

Capital structure plays a significant role in a firm and it is one of the determinations to have a far-reaching impact on operations of firms and further development in future. Capital structure can be defined as a mix of debt and equity (Abor, 2005) and its study can be used to explain finance business activities by corporations to finance real investment (Myers, 2001). Despite that a lot of western scholars attempted empirical studies on testing the optimal capital structure, the results are always different because of the complexity and particularity of applied economics and national economics. As far as now, there is no a specific answer to prove its relationship between capital structure and firm’s profitability. Some

Equity and Debts are two ways in which firms raise capital. Debt providers’ have no claim to a firm 's profits outside of the financing agreement. The upside for lenders is capped from the onset of the transaction at the interest rate, but their downside is also mitigated through loan covenants and collateral requirements (The Motley Fool, n.d.). Equity holders have a legal claim over a company’s assets and therefore pushing them to the top of the chart when a company is paying out returns. There is always a conflict of interest between the debt and equity providers when shareholders and directors attempt to maximise the value of equity and not the firm (Stefano , et al., 2013). Debt providers charge higher interest

There are three main capital structure theories which materialized from the reflections on the Modigliani and Miller (MM) Theorem (1958) first static tradeoff theory, Agency cost theory and Pecking order theory. This study is undertaken in Pakistan perspective.