Pecking Order Theory: The Four Types Of Capital Structure Theory

Pecking order theory

Capital structure theory is how the business is financed in a systematic way through liabilities and equities. Financial management comes from three sources which are internal funds, debt and equity. Modern theories of capital structure begin with study made by Modigliani and Miller in 1958. There are four types of capital structure theories which are, pecking order theory, trade off theory, signaling theory, and agency cost theory.

Pecking order theory was suggested by Donaldson in 1961 and was improved by Stewart C. Myers and Nicholas Majluf in 1984. This theory focused more on asymmetric information. In this theory, a company’s sources of financing should focus more on internal funds, follows by debt, and lastly is

This theory is about the trade-off between tax benefits of debt and expected cost of bankruptcy (Kraus & Litzenberger, 1973). Based on Modigliani-Miller theorem, when corporate income tax was added to the original irrelevance, benefit for debt is created because debt is excluded from taxes. Hence, this shows that the company is fully financed by debt. However, if the earnings of the company are insufficient to pay the debt, it will lead to bankruptcy. It is assumed that the only solution to prevent bankruptcy is by ensuring that the marginal costs and marginal benefits are balanced. Trade off theory also suggests that the marginal expected bankruptcy cost should equal to the marginal tax benefit of

Miller (1977) and Graham (2000) states that direct bankruptcy costs are very small and level of debt is below optimal. While Molina (2005) and Almeida and Philippon (2007) finds out that indirect bankruptcy can total up to 25-30% of assets value hence, comparable with tax benefits of debt. According to Green and Hollifield (2003) and Gordon and Lee (2007), if one included personal tax in basic model, tax advantage of debt can be reduced.

There are two types of trade off theory which are static trade off theory and dynamic trade off theory. Static trade off theory strongly believes that companies have optimal capital structures which are determined by exchanging the cost against the benefits of the use of debt and equity. Instead of having debt tax shield, this theory also have a potential financial distress when the company relies too much on debt. Hence, this leads to the tradeoff between the disadvantage of higher risk of financial distress and the tax