Pecking order theory

Pecking order (Myers and Majluf, 1984) theory suggests that management prefer internal

over external finance, debt over equity, and is based upon four key assumptions. The first

assumption states that companies will prefer internal finance to external finance. The

second assumption is if external finance is required, then the company issues the safest

security first. The third and fourth assumptions surround dividends, with a target

dividend payout ratio being adopted and adjusted to if required, to ensure the dividend

payouts are constant irrespective of the company’s profits (Myers and Majluf, 1984).

However, when considering the total debt and equity that is issued between 1973 and

1982 for non-financial companies, 62% of capital expenditure that is required is through

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(Brealey and Myers, 1984). The capital market is referred to in the capital structure

literature; however, there are also assumptions attached, these mainly surround the

ECMH (Fama, 1970). Semi-strong form of efficiency holds if the markets are said to be

perfect; managers tend to avoid external finance because they risk becoming ruled by the

capital markets. The modified pecking order theory describes how financial slack is

created by issuing stock, even if the investment is not needed immediately; this has the

impact of moving the company down the pecking order (Myers and Majluf, 1984). The

heavy reliance on the capital markets is high in this study of listed UK companies.

Whilst the financing decision so far has revolved around debt or equity, or a mixture of

the two, there is a third form of financing projects which is preferred, and this is called

retained earnings, or internally generated funds. If the retained earnings have been

utilised and more funds are required, a company will take on debt, and only then if funds

are still required will equity be sourced; this is called the pecking order of financing.

These types of finance can also be classified into internal, i.e. retained equity, and

external, which can be either debt or equity. This is the opposite of Miller’s (1977) trade-

off theory because there is no target capital structure and equity is split into internal and

external, with one being much higher up in the pecking order than the other (Myers and

Majluf, 1984).

Issuing external equity has several issues, including the time it takes to physically obtain

the finance. The main issue surrounds the price and timing implications of issuing equity

(Myers and Majluf, 1984). If a company issues a rights issue, it demonstrates to the

market that it has used up all of its retained earnings and it may have exhausted its debt

capacity, therefore implying that the company requires finance urgently (Myers and

Majluf, 1984). Research carried out (Myers and Majluf, 1984) finds that companies will

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underpriced shares opt to raise debt instead of equity, this is called ‘adverse selection problem’. A model is created that consists of four aspects (Myers and Majluf, 1984), whereby managers have information that shareholders do not. The first aspect is when

finance is required, you should issue safe as opposed to risky securities first. If a

company is in the situation whereby the need for investment is outstripping cash flows,

with the possibility of taking out safe debt having been used up, then they should choose

not to invest, rather than take on risky securities. The second aspect concerns dividends;

these can be reduced or not paid out in order to build up financial slack, to enable

companies to avoid losing out on the opportunity of investments due to a lack of finance.

The paying out of dividends should not occur if the necessary cash requires the issue of

equity, or another risky security (Myers and Majluf, 1984). The third aspect concerns the

issuing of shares, if equity is used to finance investments, the share price will fall, while

if default risk free debt is taken out the share price will not fall. The last aspect is in

relation to merger and acquisition activity, if a slack rich company takes over a slack poor

company, the result will be an increase to the firm’s combined value (Myers and Majluf, 1984).

In accordance with pecking order theory (Myers and Majluf, 1984), it states that

managers objectives fall into three areas. Firstly, management will act in the interests of

all shareholders and will not differentiate between old and new shareholders. Secondly,

managers assume shareholders are passive and act in their interests only. Thirdly,

shareholders are not passive, and are rational through the process of adjusting their

portfolio, depending on the company’s past decisions. The very nature of the UK stock market, combined with the high degree of liquidity enables the companies in this study to

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Pecking order theory was identified 26 years following M&M; the very nature of it

assumes how equity is taken out as a last resort. Companies issue equity on a frequent

basis, the reasons behind this go beyond this theory. One issue with pecking order theory

is the use of equity, Frank and Goyal (2009) state that companies issue too much equity

and at the wrong time (Fama and French, 2002). A deficit in finance drives companies to

choose debt over equity; there are other factors that appear to drive the use of debt in the

capital structure (Frank and Goyal, 2009). Research on pecking order theory focuses on

the debt capacity (Lemmon and Zender, 2004), and the complex selection models (Halov

and Heider, 2004). The pecking order theory (Myers and Majluf, 1984) states that equity

is issued as a last resort; a counter argument to this is the market timing theory. This

theory states that you issue equity during times when share prices are over-priced and

therefore leverage decreases, while leverage increases when share prices are undervalued.

The market timing theory is the opposite of the theory on optimal capital structure.

However, it has been shown that the result of regularly changing debt and equity levels is

why this occurs, and firms do have a debt-equity target, which they move to gradually

(Kayhan and Titman, 2007). Managers suffer should a company go into liquidation; and

leverage levels will increase if they are confident about the future. The uptake of debt

sends signals to the market, leading to an increase in the share price, and therefore

decisions concerning leverage are often considered thoroughly before being announced to

shareholders (Ross, 1977). Issuing debt enables banks to take a controlling stake in the

business. This is in comparison to issuing equity which gives control to the shareholders;

control is a key aspect that requires consideration in the leverage decision. For example,

if a company wishes to issue equity and retain its current shareholder base, this may not

be possible if not all the shareholders have the money to purchase the additional shares,

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factor to consider (Modigliani and Miller, 1963), whilst we may encourage the increase in

the total debt taken out due to the tax shield value rising, a company may not earn

sufficient profits to benefit from this. The theory of capital structure includes many

factors described above. One factor that ignores all the theories is to simply follow what

is happening in your industry, and observe how the market is reacting to other companies,

and this is called industry group leverage (Arnold, 2012). There is no exact formula that

tells companies the optimal capital structure, and often factors that are very difficult to

measure and quantify play a part.

Pecking order theory (Myers and Majluf, 1984) is a fundamental theory in this study.

Companies often have a variety of debt and equity capital sources available to them, the

active decision of choosing between the two could be guided by pecking order theory as

opposed to the independent variables within this study. This will be measured using three

different measures of debt to identify if the duration of debt is impacted via the

independent variables.