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50 Implications of the Pecking Order
There is no target debt ratio or optimal capital
D/E depends on financing needs: when firms
accumulate cash from profits they retire debt; they
issue debt when cash flows are low
Thus, the main empirical implication is that more
profitable firms use less debt (more internal cash,
don’t need debt)
Companies like financial slack. Having cash available
for projects avoids the need to issue undervalued
The Market Timing Theory
Firms try to time the market by issuing debt when it is
cheap and equity when it is cheap
Managers look at current conditions in both debt and
If they need financing, they will use whichever market
looks more favorable. If neither market looks favorable,
then fund raising may be deferred
If conditions look unusually favorable, then funds may be
raised even if they are not currently required
raised 52 The Market Timing Theory
When the firm’s market-to-book ratio is higher, as when
the firm’s equity has increased in price, then it will tend
to issue more equity
If interest rates are high (e.g., high Treasury Bill rates),
then firms will tend to rely less on debt financing
If inflation is expected, then a manager timing the market
will increase debt since he can pay off its nominal debt in
devalued 53 Empirical Facts About Capital Structure
Low debt/asset ratios: < 50% in general.
Firms don’t use up all available tax shelters.
Prices rise in response to debt increases, fall for
equity increases: This probably has more to do with
signaling than anything. We will talk about these
issues in Lecture 13.
issues 54 Empirical Facts About Capital Structure
Persistent inter-industry differences
– Low debt in growth industries (higher expected
– Significant tangible assets go with high debt
(tangible assets reduce costs of financial distress)
– Very risky enterprises have lower debt levels
– Profitable firms issue less debt
This fits best with pecking order hypothesis –
managers like to keep their free cash flow
Contradicts optimal capital structure theory:
profitable firms need tax shelter from debt more
55 Selected Empirical Findings From Frank&Goyal
Variable Trade-off Pecking Order Market Timing Finding Accounting profits + - NA - Market-to-book ratio - NA - - Firm size + NA NA + Growth - NA NA Industry leverage + NA NA R&D expenses - + NA Asset tangibility + NA NA Tax rate + NA NA Depreciation - NA NA Dividends NA + NA Investment grade NA - NA Cash-flow volatility - + NA Interest rates NA NA - Expected inflation NA NA +
+ - + How to Determine OPTIMAL Capital
Structure in Practice?
We know that important things are:
– Taxes (marginal rate to be more precise)
– Asset risk
– Asset tangibility
– Free cash flow and agency costs of equity
– Agency costs of debt
Talk to your investment banker about various rS and rB numbers
at different debt levels.
Compare with other firms in your industry (a little bit circular
reasoning though). 57 How to Determine OPTIMAL Capital
Structure in Practice?
Seems like managers work incrementally, by a
process involving experience and intuition.
Type of technology: for example, more capital
intensive firms require external financing to purchase
Maybe managerial preferences are just as important
as shareholder wealth maximization? Can managers
bypass governance mechanisms? Important issue!
More about this on Lecture 12
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This document was uploaded on 03/09/2014 for the course COMM 371 at The University of British Columbia.
- Spring '13