1. Capital Structure Theory
Pecking Order

2. The Pecking-Order Theory
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient
Rule 1: Use internal financing first
Rule 2: Issue debt next, equity last
According to the pecking-order theory:
There is no target D/E ratio
Profitable firms use less debt (they use self-financing instead)
Companies like financial slack

3. Pecking Order Theory
The 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 funds
External funds
Debt
Equity

4. Pecking Order Theory
There 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 Theory
3. 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 overvalued
Debt financing inference – firm is correctly or undervalued

6. Pecking Order Theory
The 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 Ratios
Changes in leverage affect firm Value
Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes
Another interpretation is that firms signal good news when they lever up
Capital structure varies across Industries
There is some evidence that firms behave as if they had a target D/E ratio

8. Factors in Target D/E Ratio
Taxes
If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt
Types of assets
The costs of financial distress depend on the types of assets the firm has
Uncertainty of operating Income
Even without debt, firms with uncertain operating income have high probability of experiencing financial distress
Pecking order and financial slack
Theory 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 Market
Pharmaceuticals 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 debt
Direct costs
Lawyers’ and accountants’ fees
Indirect Costs
Impaired ability to conduct business
Incentives to take on risky projects
Incentives to underinvest
Incentive to milk the property
Three techniques to reduce these costs are:
Protective covenants
Repurchase of debt prior to bankruptcy
Consolidation of debt

11. Summary and Conclusions
Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt
Value of firm under MM with corporate taxes and debt
Value of firm (V)
Present value of tax shield on debt
VL = VU + TCB
Maximum firm value
Present value of financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
Debt (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 debt
Present value of financial distress costs
Value of firm (V)
Present value of tax shield on debt
VL = VU + TCB
VL < VU + TCB when TS < TB
but (1-TB) > (1-TC)×(1-TS)
Maximum firm value
VU = Value of firm with no debt
V = Actual value of firm
Agency Cost of Equity
Agency Cost of Debt
Debt (B) B*
Optimal amount of debt