PeckingOrder Theory is the theory thatstates that the cost of financing increases with asymmetric information. Thefunding available to firms in this theory, first, Retained Earnings which haveno adverse selection problem. Second, Equity which is subject to serious adverseselection trouble while debt has only a minor adverse selection job or tasks.
Companiesusually prefer financing that comes from internal funds, debt, and issuing newequity, respectively when it comes to methods of raising capital. Outside investors tend to think managers issue newequity because the firm is overvalued and wish to take advantage, so equity isa less desired way of raising new capital. This then gives the outsideinvestors an incentive to lower the value of the new equity. The course of debta firm chooses can act as a sign of its need for external finance. Trade-offTheory indicates that a firmis said to follow the static trade-off theory if the firm’s leverage isdetermined by a single period trade-off between the tax benefits of debt andthe deadweight costs of bankruptcy. It is also refer to a firm that exhibittarget adjustment behaviour even if the firm has a target level of leverage andthe deviation from that target are gradually removed over time.
The theory impliesthat firms have a target debt ratio until they gradually adjust. The debt isadjusted by comparing the actual level or ratio of debt in the previous periodwith the predetermined target debt level or ratio.Theword signal is generally defined to convey information or instructions by meansof a gesture, action, or sound. Signals are all around us.In the world of finance, SignalingTheory assumes that firms with higher performance use financial informationas a tool to transmit signals to the market. It is useful for describingbehavior when two parties have access to different information.
The theory focusedon information asymmetry among parties that are involved in the allocation offirm funds. Financial markets are based on contractual relationships that occurunder conflicting conditions where, if one market player benefits, anotherloses. Contractual relationships reflect economic decisions which, whenapproached rationally are based on the quality, the reliability, and thetimeliness of information related to the contract. If they took debt andcouldn’t repay it, they might default and be forced to go bankrupt.Agency CostTheory refers to a supposition that demonstratesthose relationship between leads and agents in business sector . The theory isconcerned with resolving problems that can exist in way relationships due tounaligned goals or averting floor to risk of exposure . The most common agencyrelationship in finance occurs between shareholders which is principal andcompany executive directors or as knownas agents.
1. WHO CAME OUT WITH THE THEORIESThePecking Order Theory was suggested byDonaldson in 1961, it was then modified by Stewart C, Myers, and Nicholas Majlufin 1984. The theory states that company prioritize their sources of financingwhich is from internal financing to equity according to the price of financing,preferring to increase the wage or raise equity as a financing means of last resort. The internal funds will be used first,and when that is depleted, debt is issued and thus equity is issued when it isnot sensible to issue any more debt.Trade-offTheory of capital structure foundedby Kraus & Litzenberger, (Baxter 1967), suggests that firms choose theircapital structure by balancing the advantages of borrowing, mainly tax savings,with the costs associated with borrowing including bankruptcy costs.
Thistrade-off implies the existence of a target leverage that maximizes the valueof the firm. The existence of a target, which is at the heart of the theory,requires that any deviation from that target leverage should be adjusted. Thedynamic version of the trade-off theory explicitly accounts for the adjustmentbehavior of the leverage ratio where adjustments take place when the cost ofdeviation from the target exceeds the cost of adjustment towards that target(Fischer et al. 1989).SignalingTheory The first scholars to propose, explicitly,that Agency Cost Theory be created,and to actually begin its creation, were Stephen Ross and Barry Mitnick,independently and roughly concurrently. Ross is responsible for the origin ofthe economic theory of agency, and Mitnick for the institutional theory ofagency, though the basic concepts underlying these approaches are similar.Indeed, the approaches can be seen as complementary in their uses of similarconcepts under different assumptions. Ross introduced the study of agency interms of problems of compensation contracting, agency was seen, in essence, asan incentives problem.
Mitnick introduced the now common insight that institutionsform around agency, and evolve to deal with agency, in response to theessential imperfection of agency relationships: Behavior never occurs as it ispreferred by the principal because it does not pay to make it perfect. Butsociety creates institutions that attend to these imperfections, managing orbuffering them, adapting to them, or becoming chronically distorted by them. 2. ARGUMENTS OF THE THEORIESPecking Order Theory somehow is superior to the Trade-off Theory. While the trade-off model implies a static approachto financing determination based on the objective capital structure, peckingorder theory allows for the dynamics of the firm to dictate an optimal capitalstructure for a given firm at any particular point in time. (Copeland& Weston, 1988).
A firm’s capital structure is a function of its internalcash flows and the amount of positive-NPV investment opportunities available. Afirm that has been very profitable in an industry with relatively slow willhave no incentive to issue debt and will likely have a low debt-to-equityratio. A less profitable firm in the same industry will likely havea high debt-to-equity ratio. The more profitable a firm, themore financial slack itcan build up. Financial slack isdefined as a firm’s highly liquid assets plus any unused debtcapacity. (Moyer, McGuigan, and Kretlow, 2001) Firms withsufficient financial slack will be able to fund most of their investmentopportunities internally and will not have to issue debt or equitysecurities.
It allows the firm to avoid both the flotation costsassociated with external funding and the monitoring and market discipline thatoccurs when accessing capital markets. Financial managerswill attempt to maintain financial flexibility while ensuring the long-termsurvivability of their firms. When profitable firms retain theirearnings as equity and build up cash reserves, they create the financial slackthat allows financial flexibility and, ultimately long-term survival. Peckingorder theory explains these observed and reported managerial actions while thetrade-off model cannot. It also explains stock marketreactions to leverage-increasing and leverage-decreasing event, which thetrade-off model cannot. TheSignaling Theory argues that theexistence of information asymmetry can also be taken as a reason for goodcompanies to use financial information to send signals to the market . (Ross(1977).
A high payout ratio may signal a firm ashaving a confident future. Equity retained is a signal because it is notrational for a bad-news manager to retain a high equity position. Theinformation disclosed by managers to the market reduces information asymmetryand is interpreted as a good signal by the market.
The firms that want to sendthe signal that they have good prospects, will also increase their leverage. Incontrast, the overestimated firms are not willing to undertake the burden oflending because in this way they face the risk of bankruptcy.A perceivable action or structure that is intendedto or has evolved to indicate an otherwise not perceivable quality about thesignaler or the signaler’s environment. The purpose of signal is to indicate acertain quality as well.
Signaling theory useful for describing behavior whentwo parties which is individuals or organizations to have access to the informationasymmetry. Signaling occurs in competitive environment, which include dividend,leverage, voluntary disclosure, and equity retained. Information asymmetric canbe reduced if the party with more information signals to others.
These signalsare sent out in order to provide investors with more information (Spence 1973).Jensen and Meckling (1976) argued that the Agency Costs Theory are unavoidable,since the agency costs are borne entirely by the owner. They contended that theowner is motivated to see these costs minimized. If the owner manages a whollyowned firm, then he can make operating decisions that maximise his utility. Theagency costs are generated if the owner – manager sells equity claims on thefirms, which are identical to his.
It also generated by the divergence betweenhis interest and those of the outside shareholders, since he then bears only afraction of the costs of any non-pecuniary benefits he takes out maximizing hisown utility.There are two types of conflicts in the firm. First,the conflict between shareholders and managers happens because managers holdless than a hundred percent of the residual claim. Therefore, they do notcapture the entire gain from their profit enhancement activities, but they dobear the entire cost of these activities. Managers over indulge in theseinterests relative to the level that would maximize the firm value. Thisinefficiency reduced the large fraction of the equity owned by the manager.
Holding constant the manager’s absolute investment in the firm, increases inthe fraction of the firm financed by debt increases the manager’s share of theequity and mitigates the loss from the differences between the managers andshareholders.Second, they also suggested that the conflictbetween debt holders and shareholders arises because the debt contract, givesshareholders an incentive to invest sub optimally. Especially when the debtcontract provides that, if an investment yields large returns, well above theface value of the debt, shareholders capture most of the gain.
However, if theinvestment fails, debt holders bear the impacts. Therefore, shareholders maybenefit from investing in very risky projects, even if they are under valued;such investments funds termination in an adverse in the value of debt.