Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

13 - 5b EVIDENCE ON THE PECKING-ORDER AND TRADE-OFF THEORIES

The pecking-order theory is consistent with the fact that the majority (roughly 70%) of corporate

investments in Australia are funded internally through retained earnings. It also explains why profitable

companies (which have lots of financial slack) borrow less than unprofitable companies: because they

rely on internal funds rather than debt. But the pecking-order theory implies that companies have no

target capital structure, and that the debt ratios observed in the real world ought to fluctuate randomly.

The theory also seems at odds with the evidence that larger companies tend to borrow more than smaller

ones, and that companies owning more tangible assets typically use more leverage.

13 - 6 DO WE HAVE A WINNING MODEL?

Does this diversity of empirical results mean that the models we have been proposing are not helpful

to CFOs seeking the ‘best’ capital structures for their organisations? Recall the example given in the

‘What companies do’ box at the start of this chapter. We see there that the outcomes of capital structure

decisions are influenced not only by direct perceived costs of funds, but also by trends in the market

and  – although it is not a measure in the EY Capital Confidence Barometer – what competitor firms

are doing in the markets. Models such as the pecking-order framework may capture some critical

determinants of capital structures for companies, but there are other influential variables that affect the

funding decisions. These are examined in the next chapters.

12 If you were to ask senior corporate executives whether their companies’ share prices are

overvalued, undervalued or fairly valued, which do you think would be the most common

response? What does this have to do with the pecking-order theory?

13 What happens to share prices when corporate managers announce leverage-increasing

transactions such as debt-for-equity exchange offers? What happens to share prices in response to

leverage-decreasing announcements? How do you interpret these findings?

CONCEPT REVIEW QUESTIONS 13-5

SUMMARY

■ Financial leverage means using debt

financing to increase expected earnings per

share. Unfortunately, financial leverage also

increases the risk that equity investors bear.

■ Franco Modigliani and Merton Miller (M&M)

showed that capital structure is irrelevant

in a world of perfect capital markets where

investors can borrow and lend at the same

rate and managers and investors have

identical information about the company.

Their Proposition I states that the leverage

choice does not affect a company’s value.

M&M’s Proposition II says that, even though

the cost of debt is less than the cost of

equity, the WACC does not decrease when

a company reduces equity and adds debt

to its capital structure. This is because more

debt increases the cost of equity, which

exactly offsets the advantage of replacing

some equity with debt.

LO 13.4

LO13.1

LO 13.2