ULSB Assessment Brief
MN3107
Corporate Finance
Introduction
The trade-off theory and pecking order theory are regarded as two major theories that are used by a company for determining its optimal capital structure. The theories play an important role in the decision-making process by financial managers for determining the optimal level of debt in the capital structure of a firm for avoiding the occurrence of bankruptcy. In this context, the present essay seeks to provide an explanation of trade-off and pecking order theory use by companies for selecting an optimal capital structure.
Critical analysis of Trade off theory & Pecking Order Theory and choice of capital structure
Trade-Off Theory
Jahanzeb (2013) has stated that the trade-off theory has been developed by Modigliani and Miller for explaining the amount of debt and equity that should be maintained by a company in developing its capital structure. It has been stated by the theory that a company can reduce its Weighted Average Cost of Capital (WACC) by increasing the proportion of debt over equity in its capital structure. This is because debt financing is cheaper as compared with the equity financing. However, the increasing proportion of debt leads to rise in the financial risk present within the company which can offset the benefits that it can realize by enhancing the amount of debt. Hence, the theory seeks to define an optimal mix of debt and equity that should be maintained by a company so that decrease in WACC offsets the financial risk present due to rise in debt proportion.
The fact has been supported by Muneer (2012) and it has been said by the researcher that the use of debt in the capital structure leads to reduce the cost of capital by achieving tax benefits on its interest payments. In addition to this, it also helps in resolving the principal-agent problem by restricting the free cash flows to the managers and thus resolving the agency conflict. However, the theory has stated that excessive use of debt in the capital structure can lead to causing financial distress within a firm when it is not able to meet its debt obligations. Therefore, it is largely important to determine the optimal debt ratio that offsets the financial risk and leads to maximizing a firm value.
Empirical Evidence for Depicting the use of trade-Off theory for Explaining the choice of Capital Structure by Companies
In this context, the research findings proposed by Hardiyanto (2014) have proposed that proportion of debt as a significant influence on capital structure of firms. In this context, the researcher has adopted the use of partial adjustment model for providing the presence of adjustment of selected companies from Indonesia towards achieving an optimal capital structure. The data is gathered from about 228 companies of Indonesia with the use of regression techniques. The model is applied to the data selected and it has been deuced that the companies adjust their capital structure towards a defined target for gaining advantages of debt in the capital structure. As such, the researcher has focused on developing a cost-benefit analysis that can be achieved by developing an optimal debt ratio leading to maximizing a firm value. The optimal proportion of debt can be determined when the benefits of using debt are able to overweigh the financial risk that is present within a company due to debt obligations.
Consistent with the findings of the previous author stated that the researcher Leary and Roberts (2009) has stated that firms tend to maintain target leverage ratio for obtaining the advantage of debt and maximizing the value of their firm. In this context, the researcher ahs carried a comparative analysis of the capital market based system and bank based financial systems in five countries. It has been depicted by the result of the researcher that French firms rapidly adjust to the leverage while Japanese firms are slow in adjusting towards a target leverage ratio. On the contrary, Matemilola (2012) have suggested that there many factor that determines the capital structure of affirm such as tax system or corporate governance in addition to the amount of leverage. It has been revealed by the researcher that leverage ratio is negatively related to the profitability of a firm and the performance of its stocks. As such, the researchers has contradicted the views and opinions provided by trade-off theory to a large extent.
Pecking order theory
Pecking order theory has been derived to explain the capital structure and cost of capital of the company. Julius, (2012), argues that pecking order theory has been successful in explaining the difference in cost of internal capital (Retained earnings) and external capital (Debt and equity). Pecking order theory reflects that due to information irregularity between the entity and investors in regard to the real cost or values of current operations and future prospects, there will always be difference between the cost of external capital and internal capital. Further this theory has explained that external cost is relatively costlier than the internal capital due to irregularity of information between investors and firm (Julius, 2012). In this context Zurigat (2009), argued that issue of information irregularity leads mis-pricing of equity shares at the market place that will leads to loss of return to the existing shareholders. It happens due to improper selection issue that arises when managers are more knowledgeable as compared to investors. It can be explained by an example related to use of outside capital as source of finance. If any company finances its new venture or expansion plan through use of new issue of securities than it is certain that price of such securities will be low as compared to price of old securities. It is because initially managers cannot credibly provide the quality of the already existing assets and available opportunities of investment to their new investors. As a consequence, investors will not able to predict what is good or bad for their investment and they will definitely think that company’s decision of issuing new securities is bad for them and they will not take part in such securities. On the contrary investor will definitely demand for some premium on their investment to cope with the loss of their investment but in reality it is not the case. This is the reason why, companies have to issue the new securities at discount (Zurigat, 2009).
Gunarsih and Hartadi, (2017), provide a clear and important rationale regarding the decision of financial policy of the firm and it is known as pecking order theory of capital structure. As per this capital structure theory, firm tends to use internal sources of capital first through adjusting the dividend payout ratio in light of investment decision taken by them. In case, firm requires external capital due to the policy of fixed dividend policy, high fluctuations in profitability position and there is high uncertainty regarding the investment opportunities that managers will seek mostly of debt capital or hybrid capital such as convertible bonds and lastly equity (Gunarsih and Hartadi, 2017). Further Gunarsih and Hartadi, has articulated that if cash flow generated by the internal sources or business operations is greater that total outlays than company will use extra funds to pay off the debt first or if market return is more than company will invest its funds in capital market to earn more. As per this theory, business managers react differently in different situation i.e. financial behavior of finance manager react differently for surplus and deficits firms. This theory also provides that firm’s behavior upon the use of capital also depends upon the transaction cost involved for financing the capital. Transaction is occurred at the time of raising the external capital such as debt and equity (Gunarsih and Hartadi, 2017).
This theory has also faced many criticisms due to its underlying arguments and suggestions. This theory has ignored other theories and impact of institutional factors that also impact the choice of capital financing instruments such as level of interest rates relation of borrower and lender etc.
Empirical evidence for choice of capital structure in UK market as suggested by pecking order theory
Matemilola and Ariffin, (2011), have used the pecking order theory to test the capital structure choice in UK market. The results gathered by this research shows that issue of new debt capital does not have one to one relationship or direct relationship with the firms financing deficit as per pecking order theory. In this case only 22% of financing deficit has been financed with issue of debt capital (Matemilola and Ariffin, 2011).
Conclusion
It can be said for the overall
discussion held within the essay that trade theory and pecking order theory
contradicts each other. Trade theory has determined positive relation between
the capital structure and amount of debt whereas pecking order has stated that
a form should finance itself from internal finance as compared with external.
As such, it can be said that financial managers need to implement the use of
both the theories in developing an optima capital structure for deriving lager
returns on the capital employed.
References
Gunarsih, T. and Hartadi, M.M. 2017. Pecking Order Theory of Capital Structure and Governing Mechanism: Evidence from Indonesian Stock Exchange. [Online]. Available at: https://www.researchgate.net/publication/313476411_PECKING_ORDER_THEORY_OF_CAPITAL_STRUCTURE_AND_GOVERNING_MECHANISM_EVIDENCE_FROM_INDONESIAN_STOCK_EXCHANGE [Accessed on: 4 April 2019].
Hardiyanto, A. 2014. Testing Trade-Off Theory of Capital Structure: Empirical Evidence from Indonesian Listed Companies. Economics and Finance Review 3 (06) pp. 13-20.
Jahanzeb, A. 2013. Trade-Off Theory, Pecking Order Theory and Market Timing Theory: A Comprehensive Review of Capital Structure Theories. International Journal of Management and Commerce Innovations (IJMCI) 1(1), pp.11-18.
Julius, A. 2012. Pecking Order Theory of Capital Structure: Another Way to Look At It. Journal of Business Management and Applied Economics, 5, pp. 1-11.
Leary, M.T. And Roberts, M.R. 2009. Do Firms Rebalance Their Capital Structures? Journal of Finance 60(6), pp. 2575-2619.
Matemilola, B.T. 2012. Trade Off Theory Against Pecking Order Theory Of Capital Structure In A Nested Model: Panel Gmm Evidence from South Africa. The Global Journal of Finance and Economics 9(2), pp.133-147.
Matemilola, B.T. and Ariffin, A.N. 2011. Pecking Order Theory of Capital Structure: Empirical Evidence from Dynamic Panel Data. International Journal on GSTF Business review, 1(1), pp. 185—189.
Muneer, S. 2012. A Critical Review of Capital Structure Theories. Information Management and Business Review 4 (11), pp. 553-557.
Zurigat, Z. 2009. Pecking Order Theory, Trade-Off Theory and Determinants of Capital Structure: Empirical Evidence from Jordan. [Online]. Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.465.8550&rep=rep1&type=pdf [Accessed on: 4 April 2019].
