Page 201 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes to more severe market discipline and a possible loss of competitive advantage. If a firm must
use external funds, the preference is to use the following order of financing sources: debt,
convertible securities, preferred stock and common stock (Myers, 1984). This order reflects the
motivations of the financial manager to retain control of the firm (since only common stock has
a ‘voice’ in management), reduce the agency costs of equity, and avoid the seemingly inevitable
negative market reaction to an announcement of a new equity issue (Hawawini & Viallet, 1999).
Implicit in the pecking order theory are two key assumptions about financial managers. The
first of these is asymmetric information, or the likelihood that a firm’s managers know more
about the company’s current earnings and future growth opportunities than do outside investors.
There is a strong desire to keep such information proprietary. The use of internal funds precludes
managers from having to make public disclosures about the company’s investment opportunities
and potential profits to be realized from investing in them. The second assumption is that
managers will act in the best interests of the company’s existing shareholders. The managers
may even forgo a positive-NPV project if it would require the issue of new equity, since this
would give much of the project’s value to new shareholders at the expense of the old (Myers &
Majluf, 1984).

8.10.1 Capital Market Treatment of New Security Issues

The two assumptions noted above help to explain some of the observed behaviour of financial
managers. More insight is gained by looking at how the capital markets treat the announcement
of new security issues. Announcements of new debt generally are treated as a positive signal
that the issuing firm feels strongly about its ability to service the debt into the future.
Announcements of new common stock are generally treated as a negative signal that the firm’s
managers feel the company’s stock is overvalued (i.e. earnings are likely to decline in the future)
and they wish to take advantage of a market opportunity. So it is easy to see why financial
managers use new common stock as a last resort in capital structure decisions. The mere
announcement of a new stock issue will cause the price of the firm’s stock to fall as the market
participants try to sort out the implications of the firm choosing to issue a new equity issue.
8.10.2 How Pecking Order is Superior to the Trade-off Model

While the trade-off model implies a static approach to financing decisions based upon a target
capital structure, the pecking order theory allows for the dynamics of the firm to dictate an
optimal capital structure for a given firm at any particular point in time (Copeland & Weston,
1988). A firm’s capital structure is a function of its internal cash flows and the amount of positive-
NPV investment opportunities available. A firm that has been very profitable in an industry
with relatively slow growth (i.e. few investment opportunities) will have no incentive to issue
debt and will likely have a low debt-to-equity ratio. A less profitable firm in the same industry
will likely have a high debt-to-equity ratio. The more profitable a firm, the more financial slack
it can build up.

Financial slack is defined as a firm’s highly liquid assets (cash and marketable securities) plus
any unused debt capacity (Moyer, McGuigan, and Kretlow, 2001). Firms with sufficient financial
slack will be able to fund most, if not all, of their investment opportunities internally and will
not have to issue debt or equity securities. Not having to issue new securities allows the firm to
avoid both the flotation costs associated with external funding and the monitoring and market
discipline that occurs when accessing capital markets.
Prudent financial managers will attempt to maintain financial flexibility while ensuring the
long-term survivability of their firms. When profitable firms retain their earnings as equity and
build up cash reserves, they create the financial slack that allows financial flexibility and,
ultimately long-term survival.

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