In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities. Competing capital structure theories explore the relationship between debt financingequity financing and the market value of the firm. Traditional Approach According to the traditional theorya company should aim to minimize its weighted average cost of capital WACC and maximize the value of its marketable assets.
Hossain and Ali state that all firms are highly susceptible to decisions regarding capital structure, owing to their internal and external effects on organisations. They further point out that capital structure policies are significant because of their impact on the level of risk and return of a firm.
As such, a number of theories have been proposed to explain the capital structure of organisations. One of such is the Pecking order hypothesis. This essay shall examine this hypothesis and how it explains capital structure.
Subsequently, it shall be compared to another theory of capital structure, the static trade-off theory, in order to find out how it differs from this theory. Studies testing both theories shall also be examined.
According to Chen and Chenp. Frank and Goyal further note that much of its influence is drawn from a view that logically fits with facts on how external finance is used by companies. This hypothesis suggests that in making a choice among alternative forms of finance, organisations have a certain order of priorities.
In the first instance, firms prefer to make use of internal finance generated by their operating cash flow. When these internal sources are used up, they prefer to borrow. The third option, which is used as a last resort, is the sale of new shares of the company Pike and Neal, The rationale for this preference order is the information asymmetry problem, i.
As such, managers are less inclined to issue shares when they believe these shares to be undervalued, and more likely to issue them when it is believed that they are overvalued Chen and Chen, ; Pike and Neale, This could therefore increase the cost of equity for firms Pike and Neale, This is because the costs involved in obtaining finance internally are less than the transaction costs involved in securing new external financing, as internal funds do not incur transaction costs.
As such, it is expected by investors that firms would first finance company investments using internal resources first, then by borrowing till the firm has a suitable debt to equity ratio, and finally, by issuing equity Myers and Majluf, ; Pike and Neale, Frank and Goyalp.
This prediction was strongly supported by results from a study by Shyam-Sunder and Myersusing a sample of which had traded continually from to However, it should be noted that this sample was relatively small, and consisted mainly of mature, public firms.
Chen and Chen note that an assumption of the Pecking order theory is that there is no target capital structure. The pecking order theory has been used widely to explain the financing decisions of organisations.
One of its main advantages is that it correctly predicts the effects profits have Frank and Goyal, ; Shyam-Sunder and Myers, However, there are some problems with this hypothesis. As Frank and Goyalobserve, firm operations and their accounting structures are more complex than what is represented in the standard pecking order.
Furthermore, contrary to what is usually suggested, Frank and Goyal report that internal financing is usually not enough to cover the average investment spending, and there is a heavy use of external financing among firms. They also note that the magnitude of debt financing does not overshadow equity financing.
Additionally, while there is wide support for the pecking order theory among larger firms and in earlier years, with the increase in the number of small firms trading publicly, there has been a decline in the support for the pecking order hypothesis, as small firms tend not to follow the pecking order, leading to a shift in the overall average away from the pecking order Frank and Goyal, Nevertheless, the pecking order hypothesis still offers a useful explanation for the financing model followed by firms, especially larger firms.
Some studies of the pecking order hypothesis will be discussed in the next section. The static-trade off theory acknowledges that firms aim to take advantage of the lower cost benefits borrowing offers, particularly the tax shield. However, at the same time, they are also hesitant to increase the financial risks which committing to contracts and making ongoing interest and capital repayments would involve.
As such, the returns and cost benefits are traded off against the risks of financial distress from excess borrowing, and firms which have higher and more stable profits would likely operate at higher debt levels, as there would be a greater opportunity to shelter their profits from tax Pike and Neale, ; Shyam-Sunder and Myers, Figure 1 below illustrates the static trade off theory of optimal capital structure.
Shyam-Sunder and Myersp. For profitable, safe firms, which have higher taxes to shield and assets which would avoid relatively major damage to their asset values, the curve would top out at comparatively high debt ratios Shyam-Sunder and Myers, As noted earlier, in the Pecking order theory, there is no target capital structure.
This is a key difference between the Pecking order hypothesis and the static-trade off theory. Myers observes that while in the static trade off there is a debt to value ratio target set by the firm, which it steadily works towards attaining, for the pecking order theory, there is no well-defined ratio of target debt to value, but instead, internal financing is used first, before debt, and then issuing equity, due to signalling issues associated with external funding and asymmetric information Shyam-Sunder and Myers, As such, small firms tend towards issuing privately placed debt, while larger firms are more prone to issuing market debt Blackwell and Kidwell, ; Hackbarth et al, Does pecking order hypothesis explain capital structure THE PECKING ORDER HYPOTHESIS Determining the optimum capital structure which an organisation should have is a major financial decision, and the importance of decisions regarding capital structure have become even more apparent due to economic events such as the global financial crisis (Baker and Martin, ).
They further point out that capital structure policies are significant because of their impact on the level of risk and return of a firm. As such, a number of theories have been proposed to explain the capital structure of organisations.
One of such is the Pecking order hypothesis.
In corporate finance, pecking order theory (or pecking order model) postulates that the cost of financing increases with asymmetric information. The pecking order theory assumes that there is no target capital structure.
The firms choose capitals according to the following preference order: internal finance, debt, equity. THE PECKING ORDER HYPOTHESIS Determining the optimum capital structure which an organisation should have is a major financial decision, and the importance of decisions regarding capital structure have become even more apparent due to economic events such as the global financial crisis (Baker and Martin, ).
Discover capital structure theory as it relates to financial management and the methods in which companies attempt to raise capital and raise market value.