Unformatted text preview: of Static Tradeoff Theory
The Static Theory of Capital Structure VL = VU + TC × D Firm Value, VL PV(financial distress costs) VL*
PV(tax shields on debt)
Value of firm with no debt VU VU
44 A More Detailed Summary
What doesn’t matter?
– Investor preference for levered / unlevered equity:
This is the essence of MM. Investors don’t need
firms to create or undo leverage. Investors can do
Advantages to debt
– Interest tax shield
– Reduces agency costs of equity (Jensen’s free
cash flow hypothesis)
45 A More Detailed Summary
Disadvantages to debt
– Personal taxes favor equity
– In or near bankruptcy, the firm’s resources go to
lawyers and accountants
– Firms in or near bankruptcy may damage relations
with employees, suppliers, and customers
– Agency costs of debt
Excessive risk taking by management
Milking the firm
46 The Pecking Order Hypothesis
This is the main alternative to the optimal capital structure
theory (it is more like a story)
It seems to fit some of the empirical facts better than the
Key is asymmetric information: the manager must know
more about the firm’s prospects than does a typical
Investors are aware of the information asymmetry: they
try to infer this information from managerial decisions.
47 The Pecking Order Hypothesis
Managers can use their private information to “time” new
– Issue equity when it is overvalued (new sh. -, old sh +)
– Do not issue when it is undervalued (new sh +, old -),
rather issue a low-risk bond easier for investors to price
If a firm issues equity, investors will infer that it is
overvalued, and would only pay very low prices.
If it issues debt, they will infer the stock is undervalued.
Thus, to the extent possible, all firms needing to raise
external capital should issue debt, rather than equity.
48 The Pecking Order Hypothesis
Managers also have some private information about the
firm’s debt (e.g., managers know the true probability of
So it is likely that managers also tend to issue debt when
they think it is overvalued.
Taking this into account, investors will require higher
yields on bond issues.
However, investor fear of mispricing is much less for debt
than for equity.
49 The Pecking Order Hypothesis
The theory says that managers prefer the following
ordering of financing:
– Retained earnings (avoid investor skepticism)
– Debt (a little bit of information asymmetry)
– Equity (large information asymmetry)
Other reasons for the pecking order:
– Higher costs of issuance for equity than for debt
– Agency cost...
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