Capital Structure: Pecking Order

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 Whats Missing from MM?

Taxes

Distress Costs

Transaction Costs

The manager may know more about the firm than investors.
[Pecking Order]

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 What is the Pecking Order?

Firms finance investment

1 First with retained earnings
2 Then with debt
3 As a last resort, with equity

Hybrid securities (e.g., convertible debt) are between debt and equity.

The information asymmetry between the firm and the market makes:
External finance more costly than internal funds.
Equity more costly than debt.

There may be good and bad times to issue equity depending on the
degree of information asymmetry.

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How Does the Pecking Order Shape Capital Structure?

If the firm has high cash flow:

Theres no need to raise debt.
In fact, the firm can repay some debt.
Leverage decreases.

If the firm has low cash flow:

It needs to raise debt.
The firm is reluctant to issue equity.
Leverage increases.

The leverage ratio evolves from a series of incremental financing

decisions, not from an attempt to approach a target. In contrast to
the tradeoff theory, the pecking order theory implies that capital
structure can move around a lot over time.
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 An Adverse Selection Example

Suppose that a CEO tells you that investing in his company is a

wonderful opportunity, but that he needs to sell some of his personal
holdings because he needs to diversify. As a potential investor, you
think that the stock is worth either $100 per share, $80 per share, or
$60 per share with equal probability. The current price is equal to the
average value of $80.

What do you infer about the share price if the CEO tries to sell his shares?

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 Akerlofs Market for Lemons

If the CEO is selling at $80, then you infer it must be worth...

If the CEO agrees to sell at $70, then you infer it must be worth...

Foreseeing this, the CEO will only try to sell if the stock is worth...

Conversely, if the CEO is trying to buy, you infer it is worth...

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 The Manager is Reluctant to Issue Equity

The manager would prefer to issue (sell) equity when equity is

overvalued by the market.

For that reason, equity issues signal bad news to investors.

Indeed, the stock price declines at the announcement of an equity

issue.

To avoid the stock price decline, managers avoid issuing equity.

In some cases, managers may even forgo positive NPV projects that
would have been financed with new equity.

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 Example of a Positive NPV Project
The assets in place are risky:
State Probability Assets-in-Place (present value)
Good 0.5 150
Bad 0.5 50
The new investment project is safe:
Investment outlay of $12m today
Safe return of $22m next year
Discount next years return at a rate of 10%
$22m
NPV= $12m + 1.1 = $8m

Assuming no information asymmetry for now, should the manager

undertake the project:
if the firm has enough cash to finance the project?
if the firm needs to raise equity?
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When the Manager Knows as Much as Outside Investors

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 When the Manager Knows More

From the Perspective of:

Shareholders Manager
State Probability PV Assets Probability PV Assets
Good 0.5 150 1 150
Bad 0.5 50

Will the manager undertake the project if funded with cash? With equity?

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 Underpricing the Equity Issue

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In the Pecking Order, Is Debt Better than Equity?

Yes:
Raise $12m today and repay 1.1 $12m = $13.2m next year

Existing shareholders get $150m + ($22$13.2)

1.1 = $158m
Compared to $150m if they dont invest, existing shareholders gain the
full NPV ($8m).

Good firms (e.g., those with assets in place of $150m) will not want
to issue equity. They will finance with debt.

Investors infer that equity issues are from bad firms (e.g., those with
assets in place of $50m).

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 Why Is Debt Better Than Equity?
Safe debt is the same as cash:
The risk-free rate does not depend on the information.
The manager and outside investors value debt exactly the same, hence
there is no underpricing.
Risky debt may be better than equity:
Risky debt is underpriced (when the market underestimates the
probability of default and the associated losses to debtholders), but less
so than equity.
Because debt claims are fixed income securities, they are less sensitive
to the managers information.
The manager will want to issue debt rather than equity.
For very large leverage, however, the costs of financial distress should
be taken into account. In this case, equity might dominate.

The same project is worth more to existing shareholders with debt

than equity financing (unless already highly levered).
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 If the Manager can Finance Only with Equity...

Suppose the investment outlay is $18m, not $12m.

$22
NPV = $18 + 1.1 =$2m.

The manager knows that the assets-in-place are worth $150m, while
investors still assign equal probabilities to the value of those assets
being $150m or $50m.

Will the manager, on behalf of existing shareholders, undertake the

project?

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 Underinvestment

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 Market Reaction to Equity Issues

Consider again the example with the $18m investment outlay, where the
firm has no cash and cannot issue debt.
If assets are worth $150m, the firm does not invest.

Upon seeing the firm issue equity, the market infers that assets in
place are worth only $50m.

Given the markets ex-ante expectation that the firm is worth $100m,
the firms market value drops to $50m + $20m when the firm
announces the equity issue that will fund the investment project.

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 Average Stock Price Reactions

The stock price reacts when the firm announces

Equity issues: 3%

Convertible debt: 2%

Debt: 0%

Stock repurchases: +4%

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Flipping the Pecking Order to Convey Good News

If a firm wants to convey good news, it can repurchase its equity.

How?
Open market repurchase
Fixed-price tender offer
Dutch auction

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 Open Market Repurchase

By far the most common: about 95% of all repurchases

Takes a long time, about 2-3 years, because the SEC restricts
repurchases to be no more than 25% of the daily trading volume

Firms typically repurchase 5% of all outstanding shares.

No premium

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 Fixed-Price Tender Offer

Like it says, theres only one price at which shares can be bought.

Shareholders decide how many shares they want to tender.

The tendering generally happens over 20 days.

Firms typically repurchase 15% of all outstanding shares.

Worst price impact: 16% premium over current market price on

average

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 Dutch Auction
The first Dutch auction repurchase was in 1981.
The auction specifies a price range and shareholders indicate the
specific price at which they agree to tender their stock.
The firm creates a supply curve, and the purchase price is the lowest
price that allows the firm to buy its desired number of shares.
The firm pays that price to all shareholders who tendered at or below
that price.
Firms typically repurchase 15% of all outstanding shares through such
auctions.
Intermediate price impact: 12.5% premium over current market price
on average
The price impact is smaller than a fixed-price tender offer because it
exploits the lowest prices submitted.
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Increasing Dividends Is Another Way to Signal Good News
Managers smooth dividends. For example, GMs earnings and
dividends per share:

Because dividend cuts signal bad news, managers try to avoid

dividend increases that might have to be reversed.
Dividend changes follow shifts in long-run earnings.
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 Trends in Dividends Versus Repurchases

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 Pecking Order Takeaways

Firms with more asymmetrical information are more reluctant to issue

equity and try to preserve debt capacity for future investment projects.

Firms minimize the information asymmetry problem by issuing equity

immediately after earnings announcements.

Firms may signal good news through repurchases (or dividends).

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