ACF 4: Pecking order theory of capital structure

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  • Created by: charlie
  • Created on: 01-05-18 10:45
Factor driving the order: Info Asymmetry
Managers (inside) know more than investors (outside), results in issues of 1) adverse selection (before transaction) 2) moral hazard (after transaction)
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As a result of info asymmetry
Investors demand an equity premium
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Pecking order
1) Internal finance (no info asymmetry) 2) Debt (good signals: undervalue of equity + discipline) 3) Equity (bad signals: overvalue + entrenchment)
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Pecking order (1) Internal finance (+ves)
1) No issue with info asymmetry (no equity premium) 2) no signals publicly sent out about true value of equity 3) issue costs
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Pecking order (2) Debt (-ves/ +ves)
1) Info asymmetry issue (not as bad due to guaranteed payment) 2) signals equity is underpriced so increases stock price (as don't want to issue it) 3) Disciplines managers (fixed payments to debt holders)
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Pecking order (3) Equity (-ves)
1) Info asymmetry issue (no guarantee in payments) 2) signals equity is overvalued (share price falls) as want to capitalise on overvalue 3) Managerial entrenchment/ lack of discipline in managers
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Tech companies hold high cash reserves (internal finance) + prefer equity to debt
1) retain competitive advantage + finance +ve NPV projects (highly secretive industry) 2) assets are intangible (riskier) so debt has a high cost
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Other cards in this set

Card 2

Front

As a result of info asymmetry

Back

Investors demand an equity premium

Card 3

Front

Pecking order

Back

Preview of the front of card 3

Card 4

Front

Pecking order (1) Internal finance (+ves)

Back

Preview of the front of card 4

Card 5

Front

Pecking order (2) Debt (-ves/ +ves)

Back

Preview of the front of card 5
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