Dallas Business Consultant Elijah ClarkDallas Business Consultant Elijah Clark

Trade-off and Pecking-order Theories

Trade-off and Pecking-order Theories
A profitable company requires less need for external financing. To satisfy financial needs, firms will often turn to debt. A profitable company usually relies on less debt. However, according to the trade-off theory, the more cash flow a profitable firm has, the more debt it will generate. As the debt capacity accumulates, it will be used to capture tax shields and leverage benefits. Within the trade-off theory, managers seek optimal capital structure. Trade-off theory translates into empirical hypothesis as it predicts a relationship between average debt ratios and asset risk, profitability, tax status, and asset type. The pecking order theory has no optimally well-defined debt ratio. Financial distress is not a concern for the pecking order theory, and tax shields are a more attractive method to use according to the model.

The pecking order theory is built on the struggles of obtaining cost efficient financing. The theory suggests that managers should use bonds because they are a lesser risk for stock price declines. Considering firms know they will need cash within the future to manage profitable projects, they accumulate the cash today, so they will not have to forcibly go to capital markets when financing is needed. Nonetheless, because of the additional cash, managers are tempted to purchase and will likely generate wasteful spending on activities.

Pecking order theory explains the variances of debt ratios, rather than the target adjustment model based on static trade-off theory. The pecking order theory can be rejected if financing flows with the target-adjustments specified. However, the trade-off theory may appear to work, which will create false positive results from time patterns of capital expenses, which creates reverting debt ratios.

Applicable Industries
Pecking order is unlikely to do well for companies investing into intangible assets. Trade-off theory works well within industries that have room for growth and expansion. Mature industries that can practically predict their future like Coca-Cola have nothing to lose by using external funds. In 2014 The Coca-Cola Company (Coke) had a long-term debt of $19,063 million and a net income of $45,998 million. The debt ratio at Coke is optimal and is maximizing its market capitalization value at their debt levels. The company has a long-term debt of less than one year’s current net earnings. Consequently, a single year earnings can pay the debt.

Intel is a company that follows the pecking order theory, particularly because of its high-risk industry. Although the company is large, considering the technology industry is forever changing at a rapid pace, the company struggles to remain relevant, which creates the industry to be high risk. Because of the large market and competition, the company has to create innovative products and quickly get them to market. This causes a problem by not allowing revenue to fund the company’s growth, and the firm has to rely on debt to satisfy the market.

In addition to the theories, capital structure is beneficial as it presents the type of financing a firms uses. The mixture of methods includes equity and debt. To determine the right type of capital structure, firms often use a combination of debt and equity in order to maximize their market value. With leverage, a firm can lower its weighted average cost of capital. However, leverage increases financial risk of firms that must service their debt regularly. Trade-off theory helps determine the most optimal debt-to-equity ratio. Pecking-order theory allows for firms to finance themselves through retained earnings. When there are no retained earnings, the firm issues debt, and as a last resort may issue equity. Debt informs investors that management is confident with servicing the debt, and equity signals that the firm may be overvalued and could trigger a stock price fall. In regards to management, pecking-order theory suggests capital structure is rooted to agency theory and suggest that financial decisions are affected by the firms’ attempt to minimize shareholder supervision. Pecking-order theory seems to focus on examining the financial behaviors of larger firms, which have a larger borrowing capacity.

Trade-off theory focuses on bankruptcy cost and debt, which states there are advantages to debt financing. Pecking-order theory focuses on financing from internal funds, and using external funds as a last resort. Trade-off theory has dominated corporate finance circles. The pecking-order theory assumes there is no capital structure. Additionally, pecking-order can easily be applied to small firms considering smaller firms borrow based on their needs rather than optimal capital structure. Increased financial leverage affects a company’s WACC. With financial leverage, the company’s WACC decreases until optimal debt ratio is achieved, after which, the WACC rises with more debt. Increasing the debt of the capital structure also increases the tax benefits considering the interest is tax deductible. The company’s market capitalization is increased when WACC is decreased considering trade-off theory assumes the company’s risk of bankruptcy.

Diversification of Portfolios

Making an Investments
I agree with this statement. It is the decision of the employee to decide where to place their finances and trust. In regards to the Enron scenario, considering there were many options for the employees to choose from, they could have taken their investment and placed it elsewhere. Alternatives for investment options include banks in which the individual trust. For instance, when an individual is selecting a bank to place their savings or paycheck, they are likely to select the bank that they trust most. The individual makes their investment decision based on the banks track record, customer support, reliability, references, etc. In the end, if the individual were to make the wrong decision by selecting a bank, which unexpectedly closed for business, the individual could partially blame himself or herself for not researching the firm enough. It is the unfortunate reality that is often a factor in risk taking and investment decision making. It is the responsibility of the investor to research the risk tolerance of the organization that it invests in. It is not the responsibility of the organization for the investor’s bad investment. Although the organization should have morals and ethics, that cannot be guaranteed. Consequently, it becomes the responsibility of the individual or investor to do their research.

Stock Diversification
Employees and investors should not rely solely on stock options for items such as retirement plans. Often, employees over-invest into company’s like Enron because of dramatic share increases. While it may seem unlikely that a company of such magnitude could fail, stocks have the ability to plunge in value and investors can lose all of their investment in the process. It would have been more beneficial and wise had the employees diversified their stocks by only placing some funds in Enron stocks, and the rest elsewhere. Stock diversification creates less risk and minimizes the effect of a stock crash like in the case of Enron. Of the Enron stock, 89% belonged to employees and investors who chose to put their investment there. The individuals and investors had multiple options of moving their funds to a more reliable and trustworthy source or keeping it in a home safe, storage unit, or elsewhere. The fall of Enron was an unfortunate risk that the employees took and one that investors make often.

There are many excellent reasons why diversifying investments is the better decision. However, there are also many reasons as to why employees choose not to diversify. In regards to employees at Enron, they likely felt safe and confident that they were making the best decision. The company was doing very well. Sudden and unforeseen failure seemed nearly impossible based on the company’s current value at the time before the crash. The reason employers invest money into an employers stock is viewed as a psychological reason. Employees underestimate the risk associated with company stocks considering they are familiar with the company and its direction.

According to a survey by The John Hancock Financial Services Defined Contribution Plan, consumers often rate employer stocks less risky than an equity mutual fund. In addition, employees may invest into company stocks because of their loyalty to the company along with management and peer encouragement. For instance, at Enron, in 2001, CEO Ken Lay twice advised employees to purchase company stocks, promoting the bargain they would receive if they did. Within that same timeframe, Lay himself sold twenty million dollars worth of shares without disclosing to the employees. It is up to the employee to decide where to place their trust and finances. The Enron CEO situation is a clear example that employees should have been paying attention to the status of their investments and its leaders.

Concentrated investments are riskier than diversified portfolios, particularly in employee situations. The results can be devastating for employees who invest into company stocks that fail. Not only does the individual lose their job in these types of situation, but they also lose their savings and retirements. Diversifying investments protects the investor from excessive financial exposure. However, diversification causes missed opportunities of major profit gains.

Along with advantages to diversifying investments, there are also reasons as to why individuals and investors select only one investment option. By not diversifying, the investor chooses one or a few areas to invest within where they feel confident and satisfied. Often, selecting a single investment allows individuals to focus their attention on higher profit margin investments. For instance, by diversifying a $50,000 investment into 100 holdings, the investor can only expect small returns on the positive holdings. Although diversifying stocks prevent a large loss, choosing to diversify stocks will miss large opportunities of a gain.

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