3 - Pecking order and Stulz 1990 Flashcards
What does the PECKING ORDER outline?
there is a ranking in choice of finance that firms choose
What assumptions does PECKING ORDER make? 3
- asymmetric information
- dividends are sticky
- managers act in EXISTING shareholders interests
What is the ranking of financing choice according to PECKING ORDER? how is this order determined?
- internal finance
- new debt (easier to value)
- new equity
safest security first
how is level of safety of security determined in the PECKING ORDER? 2
- adverse selection costs
- sensitivity of security to new info
when will an entity issue new equity according to PECKING ORDER? 2
when they believe equity is over valued
or
they do not have enough internal cap and can not issue anymore debt
market values the share price lower than the intrinsic value, what causes this according to PECKING ORDER?
adverse selection costs
Why is debt preferred to equity as per PECKING ORDER? signals
- issuing debt signals management is optimistic about company and equity is under valued
- issuing equity signals management is pessimistic about company and equity is over valued: will drive stock prices down
why might a firm forego a positive NPV project when it is in a strong position but would have to issue equity to fund project?
because market would under value their equity issue, usually by 3%
Why does PECKING ORDER exist?
because of adverse selection costs
how do firms manage internal funds (if more or less than needed for investment opps) in regards to PECKING ORDER?
- more: pay off debt/invest
- less: draw on marketable securities
PECKING ORDER implies there are two types of equity and two types of debt financing, what are they?
- internal financing (financial slack), external financing (common equity)
- two kinds of debt, risk free and risky debt
Why is debt preferred to new equity?
information asymmetry
-issue of stock is a negative sign
why do profitable firms sell less debt?
because they can afford internal financing
what theory does the PECKING ORDER contradict? how so?
Static Trade-off Theory
firms will not have higher debt purely to gain tax shield benefit
what are key weaknesses of the PECKING ORDER theory?
doesn’t explain the differences in debt/equity ratios across industries, i.e.
- tech/high growth industries that have high need for external finance have low debt ratios
- mature industries don’t use cash flows to reduce debt and have high dividend payouts
what is a good and a bad aspect of financial slack?
- good: cash to invest in projects
- bad: becomes free cash flow to firm (left over cash), allow managers to become lazy
What does STULZ 1990 discuss?
under and over investment
What assumptions does STULZ 1990 make? 3
- managers act in their own interest
- information asymmetry regarding operating cashflow
- investors are risk neutral
When is high leverage good/bad according to STULZ? 3 states
CF/investment opps as expected: little risk of over investment
CF lower/ invest opps higher than expected: risk of underinvestment, not able to borrow more
CF higher/ invest opps lower than expects: pay off interest but is FCF there is risk over investment
When is low leverage good/bad according to STULZ? 3 states
CF/investment opps as expected: if FCF risk over investment
CF lower/ invest opps higher than expected: able to borrow more, otherwise there would be underinvestment. If they then borrow too much risk over investment
CF higher/ invest opps lower than expects: high chance of over investment
according to STULZ 1990, when are shareholders happy that firms retain funds?
when there is good investment opportunities
explain how STULZ 1990 argues that debt stops over investment from happening when there is FCF?
if high cashflows result in FCF after all positive NPV projects have been invested in, investors want managers to pay out the rest in dividends, however, managers act in their own interest and prefer to retain more funds.
If the firm has debt this FCF is used to pay off interest and prevents over investment, disciplines managers to be more efficient
What is the main thing that creates the benefits to debt according to STULZ 1990?
agency cost of management
explain, according to STULZ 1990, how debt may cause under investment?
if there is too much debt, firm can not borrow more (if it lacks FCF) to invest in good projects and may therefore have to forego them.
-can’t issue shares as share price would decrease
if there is FCF what should managers do? what do they do?
- pay out in dividends
- retain FCF- prefer more funds
in summary when is high debt good, when is high debt bad? assuming debt reduces investment
good: high CF low investment opps
bad: low CF high investment opps
According to STULZ 1990: Debt has a much wider role than the pecking order, (it is like a double-edged sword): what is meant by this statement?
- prevents over investment by disciplining managers through the repayment of debt
- many cause under investment when CFs are low, as debt must be repaid and can not issue new equity (undervalued in the market)
STULZ 1990 do managers prefer over or under investment? if CFs are volatile does this increase or decrease the problem?
over investment - they would rather invest in neg NPV projects than pay out
increased volatility increases the problem as it’s difficult for shareholders to know how much financial slack there really is.
is there optimal leverage according to STULZ 1990?
no, changes with investment opps so as to reduce risk of under/over investment
what is managerial entrenchment according to STULZ 1990?
- managers choose cap structure to avoid disciplining of debt and maintain job security
- don’t want to risk financial risk distress and job loss
- managers position themselves so that it’s to costly to remove them
How does BERGER OFEK & YERMACK 1997 agree with STULZ?
managers don’t like debt because it forces them to make un-entrenching decisions
Why is managerial entrenchment costly?
because it is not maximising effiecency
when will firms issue equity and when will they opt for debt?
- firms will issue equity when price of equity is high
- firms will opt for debt with equity value is low - stop prices decreasing further due to new equity
who is PECKING ORDER theory by?
Myers and Majluf 1984
what do BERGER OFEK & YERMACK 1997 talk about?
positive relation between firms with low debt and managerial entrenchment
- low debt = hard to remove manager because they aren’t actually decreasing firm value
according to BERGER OFEK & YERMACK 1997 in what two ways do managers entrench themselves?
- taking projects in their area of expertise
- share-buy-backs as less shares = less chance for takeovers
what do SHYAM-SUNDER and MYERS (1988) discuss?
Trade off theory - suggests:
optimal capital structure is at the point where tax shield from debt = costs of financial distress (risk premium)
what are the limitations of SHYAM-SUNDER and MYERS (1988)? what did they find?
only look at large companies - pecking order is preferred
what do FRANK & GOYLE 2002 discuss?
if pecking order or tradeoff theory are preferred
how does FRANK & GOYLE disagree with SHYAM-SUNDER & MYERS 1999?
SSM 1999 - pecking order preferred
FRANK & GOYLE 2002 - looked as small and large companies - did not find pecking order was preferred
what did FRANK & GOLYE 2002 find about small firms?
- not may people research them because of market asymmetry
- don’t have many resources to analyse their firms and provide public with info and would therefore have to issue debt even through it’s more expensive
Meyers and Majluf 1984 created which theory?
Pecking order theory
