WHY PECKING ORDER THEORY SHOULD BE INCLUDED
IN INTRODUCTORY FINANCE COURSES
Thomas J. Liesz
School of Business & Professional Studies
Mesa State College
1100 North Avenue
Grand Junction, CO 81501-3122
(970) 248-1721 or tliesz@mesastate.edu
ABSTRACT:
The majority of students majoring
in various business administration emphases take only one finance course
(Introductory Financial Management) while completing the requirements of their
degrees. A primary topic commonly
covered in most introductory finance courses is capital structure, with a
discussion that often culminates with a discussion of optimal capital
structure. Invariably the leading
textbooks present optimal capital structure within the framework of the agency
cost/tax shield trade-off model that evolved from Modigliani and Miller’s
capital structure irrelevance hypothesis.
While this approach has solid grounding in value maximization arguments
and capital market equilibrium theory, it nonetheless fails to explain several
commonly observed - and reported - practices in modern corporate finance. Pecking order theory offers an intriguing
addition to the explanation of optimal capital structure, even in an
introductory course. However, few
introductory textbooks give the theory much more than a cursory mention, if it
is indeed mentioned at all. The purpose
of this paper is to make a case for including pecking order theory in any
discussion of optimal capital structure.
Studying capital structure is an
important component of any typical introductory finance course. The topic provides closure to a
representative unit about capital budgeting and cost of capital as students discover the parameters faced by
financial managers as they determine how best to finance capital projects that
will hopefully enhance the value of their firms. Such a unit also amplifies the importance of, and provides a
stronger theoretical foundation for, financial analysis students are likely to
encounter in subsequent courses such as Business Policy or Strategic
Management. The traditional approach
found in most introductory textbooks is to present Modigliani and Miller’s
capital structure irrelevance hypothesis (Modigliani & Miller, 1958) and
then build in the effects of taxes, financial distress, and agency costs until
the “mainstream” model of optimal capital structure emerges. It is a tidy approach (often referred to as
the “Trade-Off Model”) that is easily understood under the basic underlying
tenet of optimizing value - and thus shareholder wealth - by choosing a capital
structure combination which elicits the lowest possible cost of capital for the
firm. Once the firm finds this optimal
combination of financing sources (that is, the mix of debt and equity sources
that equates the benefits of the tax shield provided by debt with the increased
costs of financial distress borne by the firm’s equity holders) the assumption is that every new dollar of
financing is raised in the same proportions of debt and equity financing. However, this approach falls short in two
different and important categories: reported and observed practice!
Two separate surveys examining
capital structure decisions revealed very similar results. In each survey financial executives were
asked which of two major criteria determined their financing decisions: 1)
maintaining a target capital structure or 2) following a hierarchy of
financing. Further, those who followed
a hierarchy were asked to rank the order in which they would use various
internal and external sources of funding.
The first survey (Pinegar & Wilbricht, 1989) was of Fortune 500
firms and the second (Hittle, Haddad & Gitman, 1992) was of the 500 largest
Over-The-Counter firms. The results
regarding which criterion was most often followed are shown in Table 1 below:
Table 1. Reported
Use of Financing Decision Methodologies
|
SURVEY AUTHORS |
RESPONDENT GROUP |
% USING
TARGET CAP STRUCTURE |
% USING HIERARCHY |
|
Pinegar & Wilbricht |
Fortune 500 Firms |
31% |
69% |
|
Hittle, et al. |
Large OTC Firms |
11% |
89% |
It is easy to see from the data in
Table 1 that in real-world practice financial managers are much more likely to
use a hierarchical approach than a target capital structure rationale when
making financing decisions. While this
would seem to be inconsistent with value maximization arguments, this behavior
is actually very rational given the motivations of managers and the vagaries of
the U.S. capital markets.
There are three observed
real-world phenomena that are difficult to explain under the agency cost/tax
shield trade-off model. These include:
1) in many industries the most profitable firms often have the lowest debt
ratios - which is the opposite of what the trade-off model would predict (Sunder & Myers, 1999); 2) large
positive abnormal returns for a firm’s stockholders are associated more
frequently with leverage-increasing events (such as stock repurchases or
debt-for-equity exchanges) than leverage-decreasing events (such as issuing
stock) (Dann, 1981 and James, 1987); and 3) few American companies issue new
stock as frequently as once per decade.
Taken together, these observed practices of American firms further
support the notion that target capital structure is not the primary criterion
used by financial managers when making financing decisions. (Megginson, 1997)
Thus, while the trade-off model is useful for explaining how financial managers can make financing decisions, it appears to have marginal explanatory value for how many financial managers actually do make these decisions in the real world. With this in mind a case for introducing students to pecking order theory to complement trade-off theory can be made. Table 2 below shows a sampling of how several popular financial management textbooks address the issue of optimal capital structure.
Table 2. Sampling
of Textbook Approaches to Optimal Capital Structure Discussion
|
TEXTBOOK |
PRESENTS ONLY TRADE-OFF |
PRESENTS BOTH MODELS |
|
Brigham, Gapenski & Ehrhardt |
|
X |
|
Brigham & Houston |
X |
|
|
Brealey & Myers |
|
X |
|
Lasher |
X |
|
|
Gitman |
|
X |
|
Moyer, McGuigan & Kretlow |
|
X |
|
Ross, Westerfield & Jordan |
X |
|
|
Van Horne & Wachowicz |
X |
|
As Table 2 shows, many of the
popular financial management and corporate finance textbooks do not present any
competing theory to the traditional trade-off model. Of the textbooks that do present both models the discussion of
pecking order is often much briefer than that of the trade-off model. Thus, many students never get exposed to any
other model than the trade-off and are left with the incorrect impression that
it is the only valid capital structure model in existence. This could lead to incorrect assumptions
regarding capital budgeting later on.
Pecking order theory of capital
structure states that firms have a preferred hierarchy for financing
decisions. The highest preference is to
use internal financing (retained earnings and the effects of depreciation)
before resorting to any form of external funds. Internal funds incur no flotation costs and require no additional
disclosure of proprietary financial information that could lead to more severe
market discipline and a possible loss of competitive advantage. If a firm must use external funds, the
preference is to use the following order of financing sources: debt,
convertible securities, preferred stock, and common stock. (Myers, 1984) This order reflects the motivations of the financial manager to
retain control of the firm (since only common stock has a “voice” in
management), reduce the agency costs of equity, and avoid the seemingly
inevitable negative market reaction to an announcement of a new equity
issue. (Hawawini & Viallet, 1999)
Implicit in pecking order theory
are two key assumptions about financial managers. The first of these is asymmetric information, or the
likelihood that a firm’s managers know more about the company’s current
earnings and future growth opportunities than do outside investors. There is a strong desire to keep such information
proprietary. The use of internal funds
precludes managers from having to make public disclosures about the company’s
investment opportunities and potential profits to be realized from investing in
them. The second assumption is that
managers will act in the best interests of the company’s existing
shareholders. The managers may even
forgo a positive-NPV project if it would require the issue of new equity, since
this would give much of the project’s value to new shareholders at the expense
of the old. (Myers & Majluf,
1984)
The two assumptions noted above
help to explain some of the observed behavior of financial managers. More insight is gained by looking at how the
capital markets treat the announcement of new security issues. Announcements of new debt generally are
treated as a positive signal that the issuing firm feels strongly about its
ability to service the debt into the future.
Announcements of new common stock are generally treated as a negative
signal that the firm’s managers feel the company’s stock is overvalued (i.e.
earnings are likely to decline in the future) and they wish to take advantage
of a market opportunity. So it is easy
to see why financial managers use new common stock as a last resort in capital
structure decisions. Just the
announcement of a new stock issue will cause the price of the firm’s stock to
fall as the market participants try to sort out the implications of the firm choosing to issue a new equity
issue.
While the trade-off model implies
a static approach to financing decisions based upon a target capital structure,
pecking order theory allows for the dynamics of the firm to dictate an optimal capital
structure for a given firm at any particular point in time. (Copeland & Weston, 1988) A firm’s
capital structure is a function of its internal cash flows and the amount of
positive-NPV investment opportunities available. A firm that has been very profitable in an industry with
relatively slow growth (i.e. few investment opportunities) will have no
incentive to issue debt and will likely have a low debt-to-equity ratio. A less profitable firm in the same industry
will likely have a high debt-to-equity ratio.
The more profitable a firm, the more financial slack it can build
up.
Financial slack is defined as a
firm’s highly liquid assets (cash and marketable securities) plus any unused
debt capacity. (Moyer, McGuigan, and
Kretlow, 2001) Firms with sufficient
financial slack will be able to fund most, if not all, of their investment
opportunities internally and will not have to issue debt or equity
securities. Not having to issue new
securities allows the firm to avoid both the flotation costs associated with
external funding and the monitoring and market discipline that occurs when
accessing capital markets.
Prudent financial managers will
attempt to maintain financial flexibility while ensuring the long-term
survivability of their firms. When profitable
firms retain their earnings as equity and build up cash reserves, they create
the financial slack that allows financial flexibility and, ultimately long-term
survival.
Pecking order theory explains
these observed and reported managerial actions while the trade-off model
cannot. It also explains stock market reactions to
leverage-increasing and leverage-decreasing event, which the trade-off model
cannot.
Pecking order theory, however,
does not explain the influence of taxes, financial distress, security issuance
costs, agency costs, or the set of investment opportunities available to a firm
upon that firm’s actual capital structure.
It also ignores the problems that can arise when a firm’s managers
accumulate so much financial slack that they become immune to market
discipline. In such a case it would be
possible for a firm’s management to preclude ever being penalized via a low
security price and, if augmented with non-financial takeover defenses, immune
to being removed in a hostile acquisition.
For these reasons pecking order theory is offered as a complement to,
rather than a substitution for, the traditional trade-off model.
While the traditional trade-off
model is useful for explaining corporate debt levels, pecking order
theory is superior for explaining capital structure changes. By including a discussion of pecking order
theory in the capital structure unit students will be exposed to a broad base
of both theory and practice that will enable them to better understand how
important financing decisions are made.
In addition to the traditional discussion of the impact of taxes,
financial distress, and agency costs upon capital structure decisions, students
will gain insight to how management motivations and market perceptions also
impact these decisions. Students will
readily appreciate the concern managers have regarding the reporting
requirements required to access capital markets. They will also be able to explain why observed practice does not
seem to always follow theory.
Furthermore, the addition of
pecking order theory into the basic discussion of capital structure provides
one more opportunity for critical thinking to occur. For example, the instructor can show how the
debt ratios of leading companies in particular industries differ from the
so-called industry averages to which most companies are usually compared during
a cross-sectional financial analysis.
Thus, a given ratio (such as a debt ratio only half the industry
average) might be argued as a “good” thing (since the firm has a large supply
of financial slack and financial flexibility) rather than as a point of concern
(the firm has opportunity costs due to not making efficient use of debt). Students will have to critically evaluate
that particular condition to judge which conclusion is correct.
To summarize, by studying pecking
order theory in conjunction with trade-off theory students will have a more
rounded exposure to optimal capital structure.
This will prepare them well for not only future courses in which they
will apply this knowledge, but also for their careers in the “real world” of
business. Table 3 summarizes the
important differences between the two theories.
Table 3. Comparison
of Trade-off and Pecking Order Theory Traits.
|
TRADE-OFF
THEORY |
PECKING
ORDER THEORY |
|
Conforms with value maximizing
construct |
Considers managerial motivations |
|
Assumes a relatively static
capital structure |
Allows for a dynamic capital
structure |
|
Considers the influence of
taxes, transaction costs, and financial distress |
Considers the influence of
financial slack and availability of positive-NPV projects |
|
Ignores the impact of capital
market “signals” |
Acknowledges capital market
“signals” |
|
Ignores concerns regarding
proprietary data |
Acknowledges proprietary data
concerns |
|
Cannot explain many real-world
practices |
Explains many real-world
practices |
As Table 3 indicates, by including
a combination of both the trade-off and pecking order theories, students will
receive a more rounded view of capital structure theory and practice. This view will better serve them both as
they work their way through the upper-division coursework in business and as
they begin their professional careers.
Accordingly, authors of textbooks
aimed at the introductory finance course are encouraged to give adequate
exposure to pecking order theory as well as the traditional trade-off
approach. And instructors of
introductory finance courses are urged to include pecking order in any
discussion of capital structure theory.
To do any less presents an unrealistic view of this important topic.
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