BUSF_A01.qxd

Pecking order theory

VG=VU+TBG−Present value of the expected cost of bankruptcy

As gearing increases, the value of the tax shield (TBG) increases but so does the

expected cost of bankruptcy. At some point the latter will outweigh the former.

This conclusion, that choosing the level of gearing requires that a balance is struck

between the tax shield and bankruptcy cost, has become known as the trade-off theory

of capital gearing.

11.12 Pecking order theory

It has been suggested, first by Myers (1984), that businesses do not follow the trade-off

theory or, at least, not to the letter.

The pecking order theoryis really concerned with the idea that businesses are

reluctant to make new share issues. There seem to be three reasons for this:

l As we saw in Chapter 8, share issues are expensive in terms of issue costs.

l It is believed that managers often feel that their business’s share price understates

its true value. Issuing new shares at this ‘low’ value would, in these circumstances,

disadvantage existing shareholders to the advantage of those taking up the new

shares issued.

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Figure 11.5
The cost of capital
for varying levels of
gearing – a possible
reconciliation of the
traditional view, the
MM (after-tax) view
and what appears
to happen in
practice

Here it is assumed that there is some logic in the MM case, and therefore WACC will fall as

gearing increases. As the level of gearing increases above a ‘moderate’ level, however, both

equity holders and lenders will become increasingly conscious of the risk. As a result they will

seek higher returns in compensation. This will drive WACC steeply up. Thus there will be an

optimum level of gearing.