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.

Market Efficiency Theory

Market Efficiency Theory
Market efficiency was formulated by Eugene Fama in 1970, labeled as efficient market hypothesis. His theory suggests that stock and market value are based on publicly available information. Investors invest with the goal that their investment will generate a positive return on their investment. An efficient capital market is when a stock price reflects publicly available information that may affect the stocks value, which could benefit investors. Efficient markets generate random patterns that cannot be predicted, and an investor cannot factually predict a stock value with secretive information.

Less Efficient U.S. Markets
Markets are much more inefficient than they used to be, and unreliable information could cause investors to receive inefficient values. If markets are unreliable, the value could potential plummet and non-informed investors may not be interested in purchasing new stock. Furthermore, An inefficient market would likely be placing a market value above or below its true value. An inefficient market creates unfair advantages for certain investors who would not otherwise have access to the company’s information. Markets become less efficient often due to greed, economic involvement, negligence, and lack of communication.

Markets in Other Countries
Many studies have found that market prices are difficult to predict. Compared to the United States, other countries also have problems with market inefficiency. Market efficiency asserts that there is no pattern or trends that can be used to predict future value. In the Indian capital market for instance, market inefficiency exist that contradict the efficient market hypothesis. A study, which examined a calendar anomaly within the stock market; found that stocks often held until after the New Year present a higher return rate, and that Monday is considered the worst day of the week to invest. While this isn’t considered inside information, it does create a predictable trend that creates a level of efficiency to use in predicting market trends and potential.

Finding efficiency within the stock market may seem fairly simple with the use of technology and cheap software tools that can find patterns within stock prices. However, the reality is that there is no way in determining the direction of a stock by using computer technology or human assumptions. In addition, if exploits did exist, they would be found and corrected to prevent future defrauding.

With the efficiency market hypothesis, the securities will always reflect the available public information. No system, tool, calculation, or individual investor has access to secret information that would help them generate a rate of return above others. Consequently, investors should always expect to receive a fair value for their securities.

To determine the direction of a stock, investors must be skilled at analyzing data, predicting stocks, and have the ability to comprehend statistics and understand the stocks industries. To achieve this, it takes an investor that is passionate and has the time to evaluate the market.

In addition to rationality, independent deviations from rationality, and arbitrage, t he efficiency market hypothesis makes the assumption that there are three levels of market efficiency’s. The three levels assume that the value of an investment should reflect all available information. Prices should change based only on publicly unexpected information. The hypothesis is considered a model based on how markets tend to work and not how they should work. The three levels of market efficiency include strong, semi-strong, and weak (Maguire, 2010; Ross, Westerfield, & Jaffe, 2013). The weak level of efficiency does not base it results on reliable data such as earnings, forecast, or company announcements. However, they are often random and based on mathematical assumptions relating to historical data. A market is considered semi-strong if it can be predicted by using publicly available information. Information that helps predict a market using a semi-strong efficiency level includes information regarding accounting statements, and historical data. The strong efficiency level uses all publicly and privately available information to determine a stocks value.

Insider trading behavior is affected by expected trading profits from private information, and potential litigation risk. Managers tend to avoid trading before company disclosures so that they may avoid litigation risk. To reduce the probability of litigation, managers provide higher quality disclosures before insider trading. Furthermore, to avoid litigation, insiders often avoid profitable trades before earnings announcements, but will trade after the announcement in an attempt to profit from their future earnings based on the announcement.

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.

READY TO GROW YOUR SMALL BUSINESS ONLINE?