Pecking and tradeoff theory

CAPITAL STRUCTURE
THEORIES
Pecking Theory and Trade off theory
By: Muhammad Owais Khan

Group Members

Pecking theory
Theory:
• Myers (1984) A firm is said to follow a pecking order if it prefers
internal to external financing and debt to equity
if external financing is used.

Pecking theory
• Adverse Section:
• The most common motivation for the pecking order is adverse
selection developed by Myers and Majluf (1984) and Myers (1984). The
key idea is that the owner-manager of the firm knows the true value of
the firm’s assets and growth opportunities. Outside investors can only
guess these values. If the manager offers to sell equity, then the
outside investor must ask why the manager is willing to do so. In many
cases the manager of an overvalued firm will be happy to sell equity,
while the manager of an undervalued firm will not.

Pecking theory
• Agency Theory:
• The idea that managers prefer internal financing to external financing
is, of course, old (e.g., Butters 1949). Traditionally the argument was
that outside financing required managers to explain the project
details to outside investors, and expose themselves to investor
monitoring. Managers dislike this process. Thus, managers have a
preference for retained earnings over external financing but their is no
direct prediction about the relative use of debt versus equity when
seeking external financing. These ideas were subsequently developed
into agency theories with Jensen and Meckling (1976) being a
prominent contribution.

Pecking theory
• Agency Theory:
• A modern corporation is a team effort involving many players,
including management, employees, share holders. The member of this
corporate team are bound together by a series of formal and informal
contracts to ensure that they pull together.
• For a long time economists assumed that all players acted for the
common good but in the last 20 years we have learn a lot about the
possible conflicts of interest and how companies try to overcome such
conflicts these ideas are collectively known as agency theory.

Pecking theory
Fund Raising Steps:
Internal Funds
New Debt
New Equity

Pecking theory
Over Price of Share:
Current price of equity
Company's performance

Pecking theory
Theory Detail:
 Internal Finance is preferred
 Target Dividend Payout Ratio
 limited Internal cash generation
 Requirement of External Finance
 Issuing of New Shares

Pecking theory
Theory Detail Cont.:
 Share Price Reponses
 Share Price and business level
 Leverage has negative relation with
profitability
 Actual debt ratio

Pecking theory
Theory Detail Cont.:
 Popularity of Internal Finance
 Less profitable firms have to borrow
more
 Leverage depend upon operating cash
flows and investment need over time

Pecking theory
Company performance:
Retention Ratio:
𝑅𝑒𝑡𝑎𝑖𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 =
Net Income − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

Pecking theory
Return on Equity:
𝑅𝑒𝑡𝑢𝑟𝑛 on Equity =
Net Income
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Pecking theory
Growth of Firm :
Growth= 𝑅𝑅 𝑥 𝑅𝑂𝐸

Pecking theory
Price of Share:
Price of Share=
𝐷𝑜
ke−𝐺

Restructuring Debt and Equity - Problems and Solutions
You have been asked to evaluate
whether a company has an appropriate amount of debt.
Debt outstanding: 1,000 EUR million
Debt rating: AAA
Market rate on bonds with rating 5.10%
Government 10-year bond rate: 4.25%
Estimated pretax profit 1600
Based on the company's interest coverage prepare a table
showing what an increase in long term debt would do to the company's ratings and its cost of borrowing
New debt Total debt New Rating Interest rate Interest expense Interest coverage ratio Debt / capitalization
0 1,000 AAA 5.10% 51 32.37 3%
2500 3,500 AA 5.10% 179 9.96 11%
5000 6,000 A+ 5.67% 340 5.70 19%
10000 11,000 A- 6.01% 661 3.42 35%

Trade - off theory
Theory:1
A firm is said to follow the static trade-off theory if the firm’s
leverage is determined by a single period trade-off
between the tax benefits of debt and the
deadweight costs of bankruptcy

Trade - off theory
Theory:2
A firm is said to exhibit target adjustment behavior
If the firm has a target level of leverage and
the deviation from that target are
Gradually removed over time

Trade - off theory
Theory Detail:
 Cost and Benefits
 Trade off between debt and equity
 Tax saving
 Distress cost
 Business risk and leverage

Trade - off theory
Different State of companies:
S.no. Total State Debt Equity Tax Loss
1 X X < 0 0 0 0 0
2 X 0 < X < B X(1-k) 0 0 kX
3 X B < X < B + φ/Tc B X-B 0 0
4 X X > B + φ/Tc B X-B-Tc(X-
B)+φ
Tc(X-B)-
φ
0

Trade - off theory

•Effect ON Debt level:
• Increase in financial distress reduce the optimal debt level
• Increase in tax increase the debt level
• Increase in non debt tax shield reduce the optimal debt level
• At optimal capital structure, an increase in the marginal bondholder
tax rate decrease the optimal debt level
Trade - off theory

THE ENDPecking Theory and Trade off theory

Pecking and tradeoff theory

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