Pecking & Trade Off Theory
Analyse the pecking order and the trade-off theories of capital structure and assess the extent to which these are supported by the empirical evidence.
Pecking Order - Introduction
The pecking order theory ( Donaldson 1961) of capital structure is among the most influential theories of corporate leverage. The pecking order theory is based on different of information between corporate insiders and the market. According to Myers (1984), due to adverse selection, firm prefer internal to external finance. If internal finance proves insufficient, bank borrowings and corporate bonds are the preferred source of external source of finance. After exhausting both of these possibilities, the final and least preferred source of finance is issuing new equity.. These ideas were refined into a key testable prediction by Shyam-Sunder and Myers(1999). The financing deficit should normally be matched dollar-for-dollar by change in corporate debt. As result, it firms follow the pecking order, then in a regression of net debt issues on the financing deficit, a slope coefficient of one is observed.
Theory
The pecking order theory is from Myers(1984) and Myers and Majluf(1984). Since it is well know, we can be brief. Suppose that there are three sources of funding available to firms: Retained earnings have no adverse selection problem. Equity is subject to serious adverse selection problems while debt has only a minor adverse selection problem.
From the point of view of an outside investor, equity is strictly riskier that debt. Both outside investor will demand a higher rate of return on equity that on debt. From the perspective of those inside the firm, retained earnings are a better source of funds all projects using retained earnings if possible. If there is an inadequate amount of retained earnings, then debt financing will be used will match the net debt issues. The pecking order theory is more concerned with the shorter run, tactical issue of raising external funds to
Pecking Order - Introduction
The pecking order theory ( Donaldson 1961) of capital structure is among the most influential theories of corporate leverage. The pecking order theory is based on different of information between corporate insiders and the market. According to Myers (1984), due to adverse selection, firm prefer internal to external finance. If internal finance proves insufficient, bank borrowings and corporate bonds are the preferred source of external source of finance. After exhausting both of these possibilities, the final and least preferred source of finance is issuing new equity.. These ideas were refined into a key testable prediction by Shyam-Sunder and Myers(1999). The financing deficit should normally be matched dollar-for-dollar by change in corporate debt. As result, it firms follow the pecking order, then in a regression of net debt issues on the financing deficit, a slope coefficient of one is observed.
Theory
The pecking order theory is from Myers(1984) and Myers and Majluf(1984). Since it is well know, we can be brief. Suppose that there are three sources of funding available to firms: Retained earnings have no adverse selection problem. Equity is subject to serious adverse selection problems while debt has only a minor adverse selection problem.
From the point of view of an outside investor, equity is strictly riskier that debt. Both outside investor will demand a higher rate of return on equity that on debt. From the perspective of those inside the firm, retained earnings are a better source of funds all projects using retained earnings if possible. If there is an inadequate amount of retained earnings, then debt financing will be used will match the net debt issues. The pecking order theory is more concerned with the shorter run, tactical issue of raising external funds to
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