2 The Pecking-Order Theory Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficientRule 1: Use internal financing firstRule 2: Issue debt next, equity lastAccording to the pecking-order theory:There is no target D/E ratioProfitable firms use less debt (they use self-financing instead)Companies like financial slack
3 Pecking Order TheoryThe pecking order theory suggests that there is an order of preference for the firm of capital sources when funding is needed.The firm will seek to satisfy funding needs in the following order:Internal fundsExternal fundsDebtEquity
4 Pecking Order TheoryThere are three factors that the pecking order theory is based on and that must be considered by firms when raising capital.Internal funds are cheapest to use (no issuance costs) and require no private information release.Debt financing is cheaper than equity financing.
5 Pecking Order Theory3. Managers tend to know more about the future performance of the firm than lenders and investors. Because of this asymmetric information, investors may make inferences about the value of the firm based on the external source of capital the firm chooses to raise.Equity financing inference – firm is currently overvaluedDebt financing inference – firm is correctly or undervalued
6 Pecking Order TheoryThe pecking order theory suggests that the firm will first use internal funds. More profitable companies will therefore have less use of external sources of capital and may have lower debt-equity ratios.If internal funds are exhausted, then the firm will issue debt until it has reached its debt capacity .Only at this point will firms issue new equity.This theory also suggests that there is no target debt-equity mix for a firm.
7 How Firms Establish Capital Structure? Most corporations have low D/V RatiosChanges in leverage affect firm ValueStock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxesAnother interpretation is that firms signal good news when they lever upCapital structure varies across IndustriesThere is some evidence that firms behave as if they had a target D/E ratio
8 Factors in Target D/E Ratio TaxesIf corporate tax rates are higher than bondholder tax rates, there is an advantage to debtTypes of assetsThe costs of financial distress depend on the types of assets the firm hasUncertainty of operating IncomeEven without debt, firms with uncertain operating income have high probability of experiencing financial distressPecking order and financial slackTheory stating that firms prefer to issue debt rather than equity if internal finance is insufficient
9 Long-term debt ratios (D/V) for selected industries Industry Book MarketPharmaceuticals 27.4% 7.34%Computers 24.75% 7.46%Steel 32.88% %Aerospace 46.32% %Airlines 71.88% %Electr. Utilities 61.74% %Auto & Truck 81.52% %Internet 18.57% 2.18%Educational services 12.97% %Source: Bloomberg, January 2005 (collected by Aswath Damodaran (NYU))
10 Summary and Conclusions Costs of financial distress cause firms to restrain their issuance of debtDirect costsLawyers’ and accountants’ feesIndirect CostsImpaired ability to conduct businessIncentives to take on risky projectsIncentives to underinvestIncentive to milk the propertyThree techniques to reduce these costs are:Protective covenantsRepurchase of debt prior to bankruptcyConsolidation of debt
11 Summary and Conclusions Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debtValue of firm under MM with corporate taxes and debtValue of firm (V)Present value of tax shield on debtVL = VU + TCBMaximum firm valuePresent value of financial distress costsV = Actual value of firmVU = Value of firm with no debtDebt (B)B*Optimal amount of debt
12 Summary and Conclusions If distributions to equity holders are taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset. In fact, the corporate advantage to debt is eliminated if (1-TC) × (1-TS) = (1-TB)Value of firm under MM with corporate taxes and debtPresent value of financial distress costsValue of firm (V)Present value of tax shield on debtVL = VU + TCBVL < VU + TCB when TS < TBbut (1-TB) > (1-TC)×(1-TS)Maximum firm valueVU = Value of firm with no debtV = Actual value of firmAgency Cost of EquityAgency Cost of DebtDebt (B)B*Optimal amount of debt