Examples Of Pecking Order Theory
Pecking order theory
One explanation of the pecking order theory is based on the information asymmetry. The asymmetric information comes from the fact that the management precisely knows, what the value of the company is, and what is the net present value of the ongoing investments, whereas the investors do not know exactly this, because they have fewer information, than the management. When the financing of a project should be decided, the management focuses on two things: the net present value of the project and the cost of finance. The project is worth financing from equity issue, if the company’s shares are overvalued (since their price is higher than their value). Overpricing occurs, if the incremental information available for the management
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This viewpoint is neglected in the professional literature, but I find it important to express this idea, because I think that the minimising of transaction cost has a big explanation power in fact. By this approach, the enterprises require at first those financing sources, whose transaction costs are smallest, and turn only to new sources, if the former sources are exhausted. There is a strict hierarchy among the sources. (Brealey & Myers, 1992) The order of the main financing sources by the theory is the …show more content…
The arguments of the pecking order theory in favour of liabilities are the followings:
1. Dilution effect – This is the point of owners. If they issue new shares, the share of existing shareholders will decline. By decreasing ownership share their influence over management also declines, and declines their share in dividend income.
2. The owners’ return expectation is always bigger, than the creditors’ one, because the owners bear higher risk. That is why the company can earn bigger amount of loan than equity for a given amount of return. The equity risk is bigger for three reasons:
a. The yield of loan is fixed in a contract. The yield of equity depends on the future performance of the company.
b. The principal of loan will be paid back sometime in the future. The equity invested in an enterprise can be withdrawn only after the liquidation of the company. The equity share can be sold earlier to another investor, but the big question is here the price.
c. During a liquidation process, the creditors are advanced against the owners. After satisfying the creditors, the owners receive very often
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