Pecking Order Theory.pptx

presentation in finanace

1. Pecking Order Theory Presented by:Samah Mahmoud Hassan

2. Agenda Introduction Components of pecking Order Theory Pecking Order Theory Factors Example Solution Conclusion Reference 2

3. Introduction The Pecking Order theory suggests that there’s an order of preference for the firm of capital sources when funding is needed This theory made popular by Stewart Myers and Nicolas Majluf in 1984,The theory states that managers follow a hierarchy when considering sources of financing 3

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5. Components Of Pecking Order Theory 5 The firm will seek to satisfy funding needs in the following order: 1-Internal Funds 2-External Funds: a-Debt B-Equity

6. Pecking Order Theory 6 Annual Review March 2, 2023 The Pecking Order theory suggests that the firm will first use internal funds. More profitable companies will therefore have less use of external sources of capital and may have lower debt-equity ratios

7. - If internal funds are exhausted, then the firm will issue debt until it has reached its debt capacity. - Only at this point will firms issue new equity. - This theory also suggests that there is no target debt-equity mix of firm

8. Factors 8 There are three factors that the pecking order theory is based on and that must be considered by firms when raising capital. Internal funds are cheapest to use and require no private information release Debt financing is cheaper than equity financing Managers tend to know more about the future performance of the firm than lenders and investors

9. Example 9 Suppose ABC company is looking to raise$ 10 million for project. The company’s stock price is currently trading at $53-77.Three options are available for ABC company:- 1- Finance the project directly through retained earnings. 2-One year debt financing with an interest rate of9% although management believes that 7% is the fair rate 3-Issuance of equity that will underprice current stock price by 7%

10. Solution 10 Option1: if management finances the project directly through retained earnings, the cost is $ 10 million Option2:If the management finances the project through debt issuance, the one year debt would cost$10.9 million($10*1.09=$10.9)Thus financing the project via debt issuance would yield a cost of $10.9 million. Option3:If management finances the project through equity issuance, to raise $10 million, the company will need to sell 200,000 shares($53.77X0.93=$50),($10,000,000/$50=200,000 shares) The true value of the shares would be $10.75 million ($53.77X200,000 shares=$10.75 million).Therefore, the cost would be $10.75 million

11. Advantages of Pecking Order Theory 11 Some of the major advantages of the pecking order theory are as follows: First, it is a useful theory that guides in verifying how information asymmetry affects the financing cost. It helps companies decide the optimal way to raise funds for financing corporate strategies, such as a new project. It shows how the company managers are eager to maintain control of the firm.

12. Disadvantages of Pecking Order Theory 12 Some of the major disadvantages of the pecking order theory are as follows: First, the theory focuses on a very limited number of variables while determining the effect on the cost of financing. It doesn’t provide any quantitative estimate of the impact of information flow on the cost of financing . Doesn’t consider financial fundraising methods

13. 13 Limitations of Pecking Order Theory Limited to a theory. Pecking order theory cannot make practical applications because of its theoretical nature. Limits the types of funding. New types of funding cannot be included in the theory. The very old theory has not been updated with newer financial fundraising methods. No-Risk vs. Reward measure to include in the cost of financing .

14. Conclusion 14 The capital structure is the particular combination of debt and equity used by a company to finance its overall operations & growth The pecking order theory states that a company should prefer to finance itself first internally through retained earnings…Finally, and as a last resort, a company should finance itself through the issuing of new equity This pecking order is important because it signals to the public how the company is performing. The theory arises from information asymmetry and explains why equity financing is the costliest and should be the last resort for financing.

15. Reference Pecking Order theory (retrieved from https:// corporatefinance institute.com/resources/knowledge/finance/pecking-order-theory/) Pecking order theory factors (retrieved from https://slideplayer.com/amp/1474384/) Pecking Order theory of capital structure (retrieved by, Murray Z Frank Vidhan K Goyal) 15

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