Influential Literature Analysis on the Pecking Order Theory: An Investigation

Table of Contents

1. Executive Summary

2. Introduction

3. Simple Example of Using the Pecking Order Theory

4. Results from the Influential Literature Analysis

5. The Pecking Order Theory in Corporate Finance Research

6. The Use of the Pecking Order Theory in Business Decisions

7. Testing the Pecking Order Theory

8. Hypothesis and Empirical Results

9. Concluding Remarks

10. References

1. Executive Summary

- The Investigation of the Influential Literature Analysis on The Pecking Order Theory researches the categorisation provided in the first assignment of this course. The focus is on explaining how authors of influential articles contributed to the evolution of this research approach.
- Based on the categorisation the papers are evaluated by highlighting their core research approach and result. In a next step this paper tries to link the approaches to present and overall picture of the underlying research area. The author introduces several hypotheses that are tested with help of empirical findings in different papers.
- The Pecking Order Theory is a theoretical concept used in finance research and business related articles. This paper shows that the theory cannot be rejected but is not fully supported. The finance decision of a company are complex and linked with its own history a single concept has not the explanatory power to give a reliable answer.
- Academic articles mainly focus on theoretical concepts. These concepts are not able to reflect the real business world. By trying to get an insight into business, the authors limit themselves by choosing data sets for special areas, companies and period of times only.
- Future research approach need to link the dynamic financial decisions of a company with a more flexible approach towards explaining the capital structure of a firm. Dynamic models are the key to get a reliable insight into managerial behaviour.
- This paper gives a good understanding of how The Pecking Order Theory evolved over time and why academics are still discussing this topic on a broad basis. By linking it to business related articles and hypotheses that are tested, the results delivered here are not biased in one direction.

2. Introduction

Every single company faces the problem of choosing the right instruments and methods for financing valuable projects with a positive NPV. The number of available instruments to choose from is growing steadily and the possible outcomes and interconnections are becoming more and more confusing even for experts from this field.

Modigliani and Miller (1958) have proven that financing decisions in a perfect and frictionless market do not matter and have no material effects on the value of the firm or its cost of capital. This logic is widely accepted by academics today (e.g. Myers 2001). However, financing can matter by changing the outside parameters. Including taxes, information problems and agency costs a somehow optimal capital structure becomes visible. All these effects have an influence on the overall level of debt vs. equity (and internal resources) a company chooses for its personal capital structure. It is still an academic and business related question which underlying theory does explain the practical approach more exactly, if any.

The most broadly used theoretical foundations managers can rely on today are the Pecking Order Theory and the Trade Off Theory. After analysing the most influential papers in the area of the Pecking Order Theory in the first assignment for this finance course and a reasoned categorisation based on the most cited papers that can be used to sort relevant articles, this paper will investigate the specific characterisation from an academic total point of view but is going to focus more on the details of the different research approaches and arguments in every category taken from the Influential Literature Analysis (ILA) on the Pecking Order Theory. This paper will also include an individual approach to evaluate and test the Pecking Order Theory based on some underlying hypothesis.

The Pecking Order Theory was the first approach to interpret dynamic changes in the structure and volume of a company’s total capital. Myers (1984) and Myers and Majluf (1984) introduced the Pecking Order Theory by including the presence of asymmetric information between managers (insiders) and stakeholders, investors (outsiders) and the typical financing behaviour of the affected companies following this theory. It is understood that all managers have the ability to evaluate the current and future situation of their own company as a result of their available inside information. Due to asymmetric information and an uncertainty about the exact firm value of the outside stakeholders, managers try to finance arising investment projects with internal funds and (riskless) debt to avoid the higher information costs associated with issuing new equity.

The Pecking Order Theory was since then used in many academic articles and research projects, either to test the whole theory or to evolve a new model based on existing ideas and proven concepts. Many authors subsequently reviewed the transferability of this theory into a practical approach, but the individual studies showed significant weaknesses, as for example, only a certain country, a selected industry or a limited period of time was considered.

The task for this paper will be to show the composition of each category out of the ILA in order to find an answer whether the Pecking Order Theory holds or lacks validity. The author tries to find an answer based on academic literature review and a hypothesis analysis within an individual test of the Pecking Order Theory.

3. Simple Example of Using the Pecking Order Theory

This chapter will give a simple example of how managers and investors interact in favour of the Pecking Order Theory. The example gives a basic numerical understanding of the approach. The author will use this example in order to value research hypothesis in a later chapter and for giving the readers a more practical point of view.

A company has the opportunity to undertake an investment project in t0 with a net present value of I. Investors on the capital market are risk neutral and the investment project can only be undertaken as a whole. Managers act in the favour of existing shareholders. The amount of cash C of the company is smaller than the net present value I. In order to finance this project the company needs to raise new equity. The volume of new shares is therefore E=I-C.

There are tow possible states of the world (S_i and S₂ ) with the same possibility of

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To finance the project the company needs to raise 150 in t0

- The company has no cash available (therefore E=I=150)

If the company invests in the available opportunity without looking at the different states of the world, the market value would be M= 145. If insider knowledge is included, S1 will lead to:

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The share value at time t0 is M+E. Therefore the value of the old and the new share is

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Issuing new shares is an advantage for new investors as the value rises from 150 to 177.97.

The same approach for the second state of the world gives: V (S2) = 240;

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Now the new investors would pay too much, as the value is below the actual market value.

Because the managers of the company act in favour of the existing shareholders they will not invest in the project in the first state of the world because they would realise a loss (-7.97). In the second state of the world, existing shareholders gain a positive 37.97 due to issuing new shares. It gets clear that a company will not always undertake a project with a positive NPV if it is completely financed with equity. The behaviour if the firm leads to a negative Signalling-Effect that is not visible when financing projects with (riskless debt) or retained earnings.

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