The pecking order theory
Fahid Fayaz Darangay
We need to look at the capital structure decision from a different point of view…the pecking order theory of Myers and Majluf (1984) and Myers (1984). Myers and Majluf analyzed a firm with assets-in-place and a growth opportunity requiring additional financing. They assumed perfect financial markets, except that investors do not know the true value of either the existing assets or the new opportunity. Therefore, investors cannot precisely value the securities issued to finance the new investment.
Assume the firm announces an issue of common stock. That is good news for investors if it reveals a growth opportunity with positive net present value. It is bad news if managers believe the assets-in-place are overvalued by investors and decide to try to issue overvalued shares. (Issuing shares at too low a price transfers value from existing shareholders to new investors. If the new shares are overvalued, the transfer goes the other way.)
Myers and Majluf (1984) assumed that managers act in the interest of existing shareholders, and refuse to issue undervalued shares unless the transfer from “old” to new stockholders is more than offset by the net present value of the growth opportunity. This leads to a pooling equilibrium in which firms can issue shares, but only at a marked-down price. Share prices fall not because investors’ demand for equity securities is inelastic, but because of the information investors infer from the decision to issue; it turns out that the bad news (about the value of assets in place) always outweighs the good. Some good firms whose assets-in-place are undervalued at the new price will decide not to issue even if it means passing by an opportunity with a positive net present value.
The prediction that announcement of a stock issue will immediately drive down stock price was confirmed by several studies, including Asquith and Mullins (1986). The average fall in price is about 3 percent, that is, 3 percent of the pre-issue market capitalization of the firm. (The falls in price are much larger fractions of the amounts issued.)
This price drop should not be interpreted as a transaction cost or compared to the underwriting spreads and other expenses of stock issues. On average, the companies which issue shares do so at a fair price.10 However, the companies that decide to issue are, on average, worth less than the companies that hold back. Investors downgrade the prices of issuing firms accordingly.
The price drop at announcement should be greater where the information asymmetry—in this case, the manager’s information advantage over outside investors—is large. Dierkens (1991) confirms this using various proxies for information asymmetry. D’Mello and Ferris (2000) show that the price drop is greater for firms followed by few security analysts, and for firms with greater dispersion of analysts’ earnings forecasts.
Now suppose the firm can issue either debt or equity to finance new investment. Debt has the prior claim on assets and earnings; equity is the residual claim. Investors in debt are therefore less exposed to errors in valuing the firm. The announcement of a debt issue should have a smaller downward impact on stock price than announcement of an equity issue. For investment-grade issues, where default risk is very small, the stock price impact should be negligible. Eckbo (1986) and Shyam-Sunder (1991) confirm this prediction. Issuing debt minimizes the information advantage of the corporate managers.
Optimistic managers, who believe the shares of their companies are undervalued, will jump at the chance to issue debt rather than equity. Only pessimistic managers will want to issue equity—but who would buy it? If debt is an open alternative, then any attempt to sell shares will reveal that the shares are not a good buy. Therefore equity issues will be spurned by investors if debt is available on fair terms, and in equilibrium only debt will be issued. Equity issues will occur only when debt is costly—for example, because the firm is already at a dangerously high debt ratio where managers and investors foresee costs of financial distress. In this case, even optimistic managers may turn to the stock market for financing.
This leads to the pecking order theory of capital structure:
1) Firms prefer internal to external finance. (Information asymmetries are assumed relevant only for external financing.)
2) Dividends are “sticky,” so that dividend cuts are not used to finance capital expenditure, and so that changes in cash requirements are not soaked up in short-run dividend changes. In other words, changes in net cash show up as changes in external financing.
3) If external funds are required for capital investment, firms will issue the safest security first, that is, debt before equity. If internally generated cash flow exceeds capital investment, the surplus is used to pay down debt rather than repurchasing and retiring equity.As the requirement for external financing increases, the firm will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock, and finally to equity as a last resort.
4) Each firm’s debt ratio therefore reflects its cumulative requirement for external financing. The preference of public corporations for internal financing, and the relative infrequency of stock issues by established firms, have long been attributed to the separation of ownership and control, and the desire of managers to avoid the “discipline of capital markets.” For example, Baumol (1965, p. 70) argued: “A company which makes no direct use of the stock market as a source of capital can, apparently, proceed to make its decisions confident in its immunity from… punishment from the impersonal mechanism of the stock exchange.” Myers and Majluf (1984) suggest a different explanation: Managers who maximize market value will avoid external equity financing if they have better information than outside investors and the investors are rational.
The pecking order theory explains why the bulk of external financing comes from debt. It also explains why more profitable firms borrow less: not because their target debt ratio is low—in the pecking order they don’t have a target—but because profitable firms have more internal financing available. Less profitable firms require external financing, and consequently accumulate debt.
(The author is currently perusing Masters in Financial Economics from Madras School of Economics, Chennai)