Pecking Order Theory
Pecking order theory arises from the concept of asymmetric information. Asymmetric
information occurs when one party possesses more information than another party, which
causes an imbalance in transaction power.
Company managers typically possess more information regarding the company’s
performance and future outlook than external users.
Internal financing comes directly from the company and minimizes information asymmetry.
As opposed to external financing, such as debt or equity financing where the company must
incur fees to obtain external financing, internal financing is the cheapest and most
convenient source of financing.
When a company finances an investment opportunity through external financing, a higher
return is demanded because creditors and investors possess less information regarding the
company, as opposed to managers.
In terms of external financing, managers prefer to use debt over equity, since the cost of
debt is lower than the cost of equity.
The issuance of debt often signals an undervalued stock and confidence that the board
believes the investment is profitable.
On the other hand, issuance of equity sends a negative signal that the stock is overvalued,
and that the management is looking to generate financing by diluting shares in the
company.
Therefore, when considering sources of financing, the cheapest is through internal
financing, second through debt and third through equity.
IMPLICATIONS OF PECKING ORDER
Profitable firms use less debt. Profitable firms have greater internal cash flow, they will
need less external financing and will therefore have less debt.
Companies will want financial slack. To avoid selling new equity, companies will want to
stockpile internally generated cash. Such a cash reserve is known as financial slack. It gives
management the ability to finance projects as they appear and to move quickly as
necessary.
No target capital structure. There is no target or optimal debt-equity ratio. Instead, a firm’s
capital structure is determined by its need for external financing, which dictates the amount
of debt the firm will have.
Agency Cost Theory
The agency cost theory of capital structure states that an optimal capital structure will be
determined by minimizing not only financial distress but also costs arising from conflicts
between parties involved.
Conflict that may exist between shareholders and debtholders, and shareholders and
managers.
Managers are more likely to operate the firm as efficiently as possible to meet the
requirement of debtholders.
Solution:
- Increasing debt level to reduce management inefficiency
- Implementing equity incentive plan to encourage managers
Agency Costs of Equity between Shareholders and Managers
Managers use resources to further their own goals, at the expense of shareholders’ goals.
Example: management may not take risky projects that would benefit the business because
if project fails, they may lose their job.
This is more probable in firms with high amount of free cash flows.
In these firms, adding debt is beneficial to shareholders because the interest payments
reduce the free cash flow available to the manager
It also causes a disciplining effect on the manager to pursue optimal policies to meet the
regular interest payments.
Therefore, shareholders might consider issuing debt in these types of firms.