Well-planned financial management and a careful assessment of the factors affecting the capital structure are essential for a company. They help achieve positive operational performance and profit. Wrong decisions about the capital structure may result in long-term financial problems or bankruptcy. Therefore, there are numerous theories created to explore capital structures and the ways financial resources can be effectively managed. For example, the pecking order theory may be useful. It is rightfully considered one of the most famous theories in the sphere of finance that has direct implications for financial institutions and organizations (Baker & Martin, 2011). The theory defies the existence of target capital structure. In other words, managers choose capitals using the simple hierarchy: internal finance, debt, and equity (Bhat, 2008). In this essay, the researcher aims to explain this idea in detail and show how companies can use it in practice.
Pecking Order Theory Assumptions
Let us explain the main idea behind the theory. The pecking order theory of capital structure implies that managers follow a simple order to find the sources of finance. First, they pay attention to internal financing. If this source is not enough, then they focus on external sources and issue debt to obtain more funds. When they see no point in issuing debt, equity is used as a last possible option (Bhat, 2008). Research conducted earlier revealed that the pecking order theory is indeed more valid than, for instance, the optimal capital structure hypothesis (Ghosh, 2012).
The theory emphasizes the asymmetry of facts known to employees. It suggests that managers are generally more informed about their own company’s financial performance, while their knowledge of external financing is relatively limited (Baker & Martin, 2011). Some businesses or organizations have a high level of the so-called “asymmetric information,” which means that they know little about outside investors or creditors. Similarly, some investors know little about the company. In this case, they may demand higher returns. As a result, it is easier for such a company to use its retained earnings, which in this case are safer and more convenient source of financial resources (Bhat, 2008). Only is a company does not have enough internal sources of capital, it has to use the debt or, as a last solution, equity.
Advantages of the pecking order theory are obvious. It is simple and shows how companies can manage their capital. More importantly, it allows investors to understand whether the company is stable or not. In the first case, it uses its internal resources (retained earnings). In the latter case, it uses debt and equity. A good pecking order theory example is a company that uses the new stock to finance itself. Such a company sends a negative message to investors and creditors as it shows that it cannot operate with its internal resources only. Bhat (2008), however, mentioned some limitations of the theory. The author claimed that it does not explain the influence of agency costs, taxes, financial problems, etc. on companies’ investment opportunities.
It is important to note that the comparison is often made between pecking order theory vs. trade-off (Adair & Adascou, 2015). Static tradeoff theory is based on a different assumption. It postulates that businesses consider the amount of debt and equity they can turn to by assessing the benefits and costs. Unlike the analyzed model that highlights the importance of relying on internal capital, this theory assumes that there is nothing bad about mixing debt and equity. Notably, the trade-off theory is criticized. Compared to other theories and models, it has limited empirical relevance. Therefore, the reliance on internal financing is currently favored.
This essay sample has been written for reference only. If you need finance essay help, you can use our academic writing services. Just send “write me an essay” message and give us the assignment, and our experienced writers will do all the hard work for you. You can be sure that your paper will receive the highest grade!
Adair, P., & Adascou, M. (2015). Trade-off-theory vs. pecking order theory and the determinants of corporate leverage: Evidence from a panel data analysis upon French SMEs (2002–2010). Cogent Economics & Finance, 3(1). Retrieved from http://www.tandfonline.com/doi/full/10.1080/23322039.2015.1006477
Baker, H. K., & Martin, G. S. (2011). Capital structure and corporate financing decisions: Theory, evidence, and practice. Hoboken, NJ: John Wiley & Sons.
Bhat, S. (2008). Financial management: Principles and practice. New Delhi, India: Excel Books India.
Ghosh, A. (2012). Capital structure and firm performance. Piscataway, NJ: Transaction Publishers.