Capital Structure Considerations

How do businesses benefit from using capital structure, optimal capital structure, debt and equity, and return on investment? Businesses have the opportunity to earn more return from their investments and their blend of debt and equity capital structure. This section gives examples of how these concepts are used.

Pecking Order

In corporate finance pecking ordering consideration takes into account the increase in the cost of financing with asymmetric information.


LEARNING OBJECTIVE

  • Explain the benefits and shortcomings of using the "pecking order" theory to evaluate a company's value

KEY POINTS

    • When it comes to methods of raising capital, companies will prefer internal financing, debt, and then issuing new equity, respectively.
    • Outside investors tend to think managers issue new equity because they feel the firm is overvalued and wish to take advantage, so equity is a less desired way of raising new capital. This then gives the outside investors an incentive to lower the value of the new equity.
    • The form of debt a firm chooses can act as a signal of its need for external finance. This sort of signalling can affect how outside investors view the firm as a potential investment.

TERM

  • Pecking Order

    Theory that states that the cost of financing increases with asymmetric information. When it comes to methods of raising capital, companies prefer financing that comes from internal funds, debt, and issuing new equity, respectively. Raising equity can be considered a last resort.


Pecking Order Consideration

The pecking order of investors or credit holders in a company plays a part in the way a company decides to structure it's capital. Pecking order theory basically states that the cost of financing increases with asymmetric information. Financing comes from internal funds, debt, and new equity. When it comes to methods of raising capital, companies will prefer internal financing, debt, and then issuing new equity, respectively. Raising equity, in this sense, can be viewed as a last resort.

The pecking order theory was popularized by Stewart C. Myers when he argues that equity is a less preferred means to raise capital because managers issue new equity (who are assumed to know better about true conditions of the firm than investors). Investors believe that managers overvalue the firms and are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required. Thus, the form of debt a firm chooses can act as a signal of its need for external finance. This sort of signalling can affect how outside investors view the firm as a potential investment, and once again must be considered by the people in charge of the firm when making capital structure decisions.

Tests of the pecking order theory have not been able to show that it is of first-order importance in determining a firm's capital structure. However, several authors have found that there are instances where it is a good approximation of reality. On the one hand, Fama, French, Myers, and Shyam-Sunder find that some features of the data are better explained by the Pecking Order than by the trade-off theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry is presumably an important problem.