Analysis Of The Pecking Order Theory

The pecking order theory assumes that there is no capital structure. In The pecking order theory mangers have a hierarchy on how to fund investment opportunities. Myers and Majluf (1984) argued that managers prefer to make use of retained income to finance investments followed by debt and finally equity. The choice on which one of the capitals is used is affected by the cost of information and information asymmetries associated with it. Retained income has a zero information costs while the issuing of equity has the most. The pecking order theory is affected by many other variables, which include the size of the firm, the firm’s profit as well as agency costs.

Firms in South Africa, firms prefer retained profits due to the high levels of asymmetric

The issuing of equity is put right at the bottom of the list because it is perceived as a sign that a firm is overvalued and managers are trying to take advantage of outside investors. This is where information asymmetries comes into play as managers are believed to have more information about the share value than the investors do. Managers can use their superior knowledge to achieve their own interest, which is to buy back the shares at low prices. This is why Investors are very hesitant to supply the equity funds because of the possibility of getting unfair returns. In the long run, the issuing of equity will lead to a reduction of the share price except for technology companies (Myers and Majluf

Firms in the infancy stage are usually small and may have insufficient retained income to use for investment. This supports the pecking order theory, which views that debt is only issued when there is insufficient retained income. These firms will need more investment to grow and therefore borrow more (Daskalakis and Psillaki, 2008). However, firms in the infant stage may have difficulty in accessing loans because banks don’t knows their future prospects and are uncertain whether the firms will be able to pay back the debt. large firms have enough retained earnings and do not need debt or equity funds. Large firms are able to take up more debt because of their size and ability to cover any financial risk. The larger a frim gets the more ability it has to reduce information asymmetries and find it easier to take on more equity (Padron et al. 2005). Firms in the decline stage need to use debt again. Infant firms have fewer agency costs because they are still run by the entrepreneur and in theory firms run by the owner have few agency costs (Ang, Cole and Lin 2000). Riskier firms in their infancy should use more equity. Risky firms include technological firms whose future is uncertain. (Morgan and Abetti