Pecking Order Theory (Richa)

Pecking Order Theory (Richa)

  • Submitted By: rrichha
  • Date Submitted: 02/09/2011 12:52 PM
  • Category: Business
  • Words: 1127
  • Page: 5
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Pecking Order theory (richa)

* Gives the Reason why companies prefer to borrow less (profitable companies)
* This theory is based on the asymmetric information that managers know about the company than the outsiders. Investors, because of the lack of knowledge might be reluctant to invest in the company. Managers at times tends to be pessimistic and at times (rather genrally) they act optimistic.
* All of these problems are avoided if the company can finance with internal funds.
* But if external financing is required, issuing debt is preferred as the safest, as there is less scope of the debt to be misvalued.
* Hence,Pecking order theory is based on these values:
* Firms pefer internal financing,since these do not send any adverse signals which might lower the stock price.
* If external financing is required, firms issue debt first and issue equity only if required, as issuing debt will less likely to be interpreted as a bad omen by the shareholders.
* In this there is no clear target about the debt-equity mix. There are 2 kinds of equity : internal (top of the pecking order)and external. (at the bottom)
* Pecking order explains why most profitable firms borrow less- it is not because they have low target debt-equity ratios because they don’t need outside money.
* Less Profitable firms issue debt ratios b’coz they do not have sufficient internal funds for their capital investment.
* The theory doesn’t deny – taxes and financial distress are imp factors in the choice of capital structure. However, it says that these factors are less important than managers preference for internal over external funds and for debt financing over new issues of common stock,

6. Agency Cost:
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