Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

13 - 5 THE PECKING-ORDER THEORY

There are three empirical regularities that seem inconsistent with companies’ choice of an optimal capital

structure according to the trade-off model:

1 The most profitable companies in some industries have the lowest debt ratios.

2 Leverage-increasing events – such as share repurchases and debt-for-equity exchange offers – almost always

increase share prices, whereas leverage-decreasing events reduce share prices. These facts suggest that

companies systematically use too little leverage and do not operate at or near the optimal target debt ratio.

3 Companies issue debt frequently, but equity issues are rare. Announcements of new seasoned equity

issues are invariably greeted with a large decline in the company’s share price, a decline that is often

equal to a third or more of the new offering’s value.

How can we account for these perplexing facts? One answer was put forward in 1984 by Stewart Myers

and Nicholas Majluf, who proposed the pecking-order theory.

13 - 5a ASSUMPTIONS UNDERLYING THE PECKING-ORDER THEORY

The pecking-order theory is based on four facts that Myers and Majluf observed about corporate financial

behaviour. First, dividend policy is ‘sticky’. Managers tend to maintain a stable dividend payment, neither

increasing nor decreasing dividends in response to temporary fluctuations in profits. Second, companies prefer

internal financing (retained earnings and depreciation) to external financing of any sort, debt or equity. Third,

if a company must obtain external financing, it will issue the safest security first. Finally, as a company requires

more external financing, it will work down the ‘pecking order’ of securities, beginning with safe debt, then

progressing through risky debt, convertible securities, preferred shares and, as a last resort, ordinary shares.

Myers and Majluf (1984) provide additional justification for the pecking order that is based on

asymmetric information. The authors make two plausible assumptions about managers: (1) a company’s

managers know more about the company’s current earnings and investment opportunities than do outside

investors; and (2) managers act in the interest of existing shareholders.

Why are these two assumptions crucial? The one about asymmetric information implies that managers

who develop or discover a marvellous new positive-NPV investment opportunity cannot convey that

information to the market because outside investors don’t believe the managers’ statements. After all, every

management team has an incentive to announce wondrous new projects, and investors cannot immediately

verify these claims. Sceptical investors will buy new equity issues only at a large discount from what the

share price would be without informational asymmetries. Corporate managers understand these problems,

and in certain cases they will reject positive-NPV investments simply to avoid selling equity to new investors

at a discount, which would have the effect of transferring wealth from old to new shareholders.

What a dilemma! Investors cannot trust managers, so investors place a low value on new issues of ordinary

shares. Managers forgo valuable projects because they cannot credibly convey their private information to

existing shareholders. Endemic information problems in financial markets do not have easy solutions.

What, then, must managers do? According to Myers and Majluf, corporations should retain sufficient

financial slack, or flexibility, to fund positive-NPV projects internally. Financial slack includes a company’s

cash and marketable securities holdings in addition to its unused debt capacity. Companies with

sufficient financial slack can finesse the information problem, because they need never issue equity to

finance investment projects. In addition, the optimal investment rule is once again in force, because

managers can accept all positive-NPV projects without harming existing shareholders. This theory also

pecking-order theory
A hypothesis that assumes
managers are better
informed about investment
opportunities faced by their
companies than are outside
investors

LO 13.3

financial slack
Large cash and marketable
security holdings in addition to
its unused debt capacity