Pecking Order Theory: Finance Choices

Pecking Order Theory Overview

• Firms prioritize the cheapest funding sources: internal funds, then external debt, and finally equity financing, which is the most expensive.
• If external funding is needed after exhausting internal funds, firms aim to maximize the benefits of debt financing, as described in the Modigliani-Miller (MM) Proposition.

Financing Choices

• Managers possess superior knowledge of the company compared to external stakeholders.
• External stakeholders assess a firm's profitability based on signals, such as equity issuance, which can be perceived negatively (overpriced shares).
• Optimistic managers prefer debt to avoid issuing undervalued equity; pessimistic managers also favor debt to avoid signaling overvaluation.
• Dividend policy influences share price: higher dividends suggest limited future projects, while dividend cuts may imply insufficient growth.

Pecking Order

• Companies primarily use internal funds, then new debt, and lastly new equity for investments.
• Retained earnings are considered another form of equity financing.
• If the cost of debt is excessively high, equity may be preferred.
• Low leverage can result from an inability to issue more debt or sufficient profitability to fund investments internally.

Information Asymmetry

• Shareholders assess the firm's profitability and credibility based on signals the company sends.
• Managers prefer to send positive signals to the market.
• Issuing equity can be perceived negatively, suggesting operational weaknesses.

Pecking Order Example 1

• Share Value Taking the Project = (PV of existing shares + PV of New Investment) / Total Numbers New and Original Shares
• Share Value Not Taking the Project = PV of Existing Value / Number of Original Shares
• Intrinsic Value is share value believed by management team if no investment is taken up. External shareholders do not know this intrinsic value, because of information asymmetry.
• Information asymmetry affects perspectives on share value after investment.
• Companies aim to raise equity when the share price is above their intrinsic value.

External Financing Preferences

• Optimistic managers issue debt to signal that equity is undervalued, attracting investors.
• Pessimistic managers, believing equity is overvalued, still issue debt to benefit existing shareholders, although issuing equity will signal that the share price is overvalued causing investors to sell shares.

Pecking Order Example 2

• ABC Ltd needs to raise $10m for a new investment.
• Required Investment Amount = $10m, Interest Rate = 7%. ABC Ltd issues equity, management believe it is underpriced by 5%.
• Retained earnings are the cheapest, while equity is the most expensive.
• The cost to existing shareholders of financing the investment out of retained earnings, debt or equity

Implications of the Pecking Order

• Firms prioritize internal funds (retained earnings) over debt and equity financing, and aim for stable dividend payouts.
• Cash flows exceeding capital expenditure lead to debt repayment or investments; lower cash flows result in drawing on cash balances.
• The theory identifies two types of equity (internal & external) and debt (risk-free & risky).

Implications of Information Asymmetry

• It explains why external debt financing is preferred over new equity issues.
• Issue stock when it is overvalued even with no investment → negative sign
• Adequate internal funds diminish the need to sell debt; less profitable firms rely more on debt.

Failure of Pecking Order

• It fails to explain debt/equity ratio differences across industries.
• High-tech growth industries have low debt ratios despite a need for external capital.
• Mature industries with ample cash flow may not prioritize debt repayment, and have high dividend payout ratios.

Financial Slack

• Financial slack, including cash and access to financial markets, is valuable.
• Financial slack becomes free cash flow, which is cash remaining after funding all positive NPV projects.
• Debt can discipline managers tempted to overinvest in below-cost-of-capital projects.
• If company has excessive cash, it will encourage managers to invest in below cost of capital investments.
• Debt financing is advantageous because it can discipline managers tempted to over invest too much

Stulz (1990)

• Challenges the pecking order, suggesting debt has a wider role beyond shareholder interests.
• With agency costs of managerial discretion, management will not voluntarily give up cash flow, and tend to over invest.
• With agency costs, debt reduces investment in all states of the world.
• There is an optimal amount of debt, which increases with expected cash flow and falls with the size of the good investment opportunities.

Stulz (1990): The Role of Debt

• Debt can resolve overinvestment by forcing managers to repay free cash flow, but may cause underinvestment if cash flow is lower than expected.
• It suggests managers overinvest in negative NPV projects rather than distribute payouts.
• Debt has a much wider role than the pecking order, (it is like a double-edged sword).
• More volatile cash flows lead to a bigger problem (ex: costly to contract ex ante).

Capital Structure Implications

• External financing relates to debt.
• Cash flows as expected: this maximises value (V)
• Lower than expected cashflow: there is too much debt issued, and managers have to issue equity which will lead to underinvestment.
• Greater than expected cashflow: there is too little debt issued, and can lead to overinvestment.
• Minimizing under- and overinvestment means there is no optimal leverage.

Managerial Entrenchment

• Managers choose capital structures to avoid the discipline of debt and secure their positions.
• Managers minimize leverage to prevent job loss from financial distress, but avoid too little debt to satisfy shareholders and prevent takeovers.
• Entrenchment is efficient but costly,
• Managers prefer suppression of the debt financing, otherwise they will be disciplined by the debtholders, resulting in change of managers.

Evolution of Capital Structure Theory

• 1958–1985: Focused on scenarios without taxes or bankruptcy costs, assuming exogenous operating decisions.
• 1976–2002: Introduced agency costs, impacting operating decisions.
• 1999–present: Considers the effects of incomplete capital markets.

Time-Series Patterns

• Academic research has focused on explaining the cross-section of debt and the market value of equity + debt.
• Found that highly profitable firms have low debt ratios.
• Firms issue equity infrequently.
• Firms sometimes issue equity after abnormal stock runups.
• Investment does not have a high sensitivity to Tobin’s Q (same as market-to-book).