Page 202 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 8: Capital Structure Decision

The pecking order theory explains these observed and reported managerial actions, while the Notes
trade-off model cannot. It also explains stock market reactions to leverage-increasing and
leverage-decreasing events, which the trade-off model cannot.

8.10.3 Limitations of Pecking Order Theory

The pecking order theory, however, does not explain the influence of taxes, financial distress,
security issuance costs, agency costs, or the set of investment opportunities available to a firm
upon that firm’s actual capital structure. It also ignores the problems that can arise when a firm’s
managers accumulate so much financial slack that they become immune to market discipline. In
such a case, it would be possible for a firm’s management to preclude ever being penalized via
a low security price and, if augmented with non-financial takeover defences, immune to being
removed in a hostile acquisition. For these reasons, the pecking order theory is offered as a
complement to, rather than a substitution for, the traditional trade-off model.

Conclusions and implications: While the traditional trade-off model is useful for explaining
corporate debt levels, the pecking order theory is superior for explaining capital structure
changes. By including a discussion of pecking order theory in the capital structure unit, students
will be exposed to a broad base of both theory and practice that will enable them to better
understand how important financing decisions are made. In addition to the traditional discussion
of the impact of taxes, financial distress, and agency costs upon capital structure decisions,
students will gain insight to how management motivations and market perceptions also impact
these decisions. Students will readily appreciate the concern managers have regarding the
reporting requirements required to access capital markets. They will also be able to explain why
observed practice does not seem to always follow theory.
Furthermore, the addition of the pecking order theory into the basic debate about capital structure
provides one more opportunity for critical thinking to occur. For example, the instructor can
show how the debt ratios of leading companies, in particular industries, differ from the
so-called industry averages to which most companies are usually compared during a cross-
sectional financial analysis. Thus, a given ratio (such as a debt ratio only half the industry
average) might be argued as a ‘good’ thing (since the firm has a large supply of financial slack
and financial flexibility) rather than as a point of concern (the firm has opportunity costs due to
not making efficient use of debt). Students will have to critically evaluate that particular condition
to judge which conclusion is correct.

To summarize, by studying the pecking order theory in conjunction with trade-off theory,
students will have a more all-round exposure to optimal capital structure. We also briefly look
at the important differences between the two theories.

8.11 Approaches to Determine Appropriate Capital Structure

The following are the approaches to determine a firm’s capital structure: EBIT - EPS Approach,
Valuation Approach and Cash flow Approach

1. EBIT - EPS Approach: This approach is helpful to analyse the impact of debt on earnings
per share.
2. Valuation Approach: This approach determines the impact of debt use on the shareholder
value.
3. Cash Flow Approach: This approach analyses the firm’s debt service capacity.
Apart from the above ROI - ROE analysis, ration analysis is also used. But here in this book, we
will discuss the first (EBIT - EPS) approach only.

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