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Tradeoff and Pecking Order

Theories of Debt
By Frank and Goyal
Presented to: Dr. Khurram S. Mughal
Presented on: 15-05-2014

Presented by:
Aneeza Younus
Zareen Fatima
Sadia Khaliq
Fahd Salman Mirza
Conceptual Framework of
theories of debt
M&M Theory
Trade-off Theories
Pecking Order
Aneeza Younus
Sadia Khaliq
Fahd Salman Mirza
Capital Structure Puzzle
Basic Question?

How do firms choose their capital
Broadly, capital irrelevance, trade off and
pecking order theories explains capital
structure decisions
Modigliani Miller Theorem

Under some assumptions, the value of
company is independent of its
leverage(debt + preferred stock)
Multiple equilibrium is determined where
debt is issued by different firms keeping
in view the personal and corporate tax
which also affect economy wide leverage
ratio such as debt to asset ratio, debt to
equity ratio etc.
Assumptions of MM Theorem
1. No consideration of taxes
2. No transaction costs
3. No costs of financial distress or bankruptcy
4. No agency costs
5. Lack of separtability between financing and
6. Investors have homogeneous expectations
of company returns or future cash flows
7. Individuals investors can borrow at the
same interest rate as that of a company or

The theory has unrealistic assumptions

Later on by filling the gaps in the theory
(assumptions), various researchers
have given their own theories

Empirically, MM theory is difficult to test

Criticism on Theory
Plus Points
It remained relevant up till 1980

Influenced the early development of
both the trade-off theory and pecking
order theory
Trade Off Theory
Theory that capital structure is based on a trade-off
between debt and equity
If debt is more, equity would be less and if debt is less,
equity would be more
Firm evaluates the various costs and benefits of leverage
Different leverage plans are dependent on taxes
(personal + corporate), bankruptcy costs, tax schedules
and transaction costs
If the actual leverage ratio deviates from the optimal one,
the firm will adapt its financing behavior in a way that
brings the leverage ratio back to the optimal level
Obtained when equilibrium or balance point is reached
between marginal benefit or marginal cost
The Static Trade Off Theory
Firms leverage is determined by a
single period trade-off between the tax
benefits of debt and the deadweight
costs of bankruptcy

The Dynamic Trade Off Theory
Presents a model of dynamic optimal
capital structure choice in the presence
of recapitalization costs such as tax
rates, tax codes, transaction and
bankruptcy costs

Capital Structure may not always
coincide with their target leverage ratios

Pecking order theory
The pecking order theory suggests that there is an order of
preference for the firm of capital sources when funding is needed.
The firm will seek to satisfy funding needs in the following order:
Internal funds
External funds
Firm size and age are important determinants of capital structure
Larger firms use less leverage
Older firms use less leverage
pecking order models can be derived based on adverse
selection consideration and agency cost.
Pecking Order Theory
There are three factors that the pecking order
theory is based on and that must be
considered by firms when raising capital.

1. Internal funds are cheapest to use (no issuance
costs) and require no private information release.
2. Debt financing is cheaper than equity financing.
3. Managers tend to know more about the future
performance of the firm than lenders and
investors. Because of this asymmetric information,
investors may make inferences about the value of
the firm based on the external source of capital the
firm chooses to raise.
Equity financing inference firm is currently overvalued
Debt financing inference firm is correctly or

Asymmetric-Information Costs
Definition: The costs of overcoming two types of
information problems:
Adverse selection: separating good from bad risks
before implementation of a financial contract.
Agency theory: insuring that economic agents
with proxy authority live up to the terms of their
Adverse selection
The key idea is that the owner-manager of
the firm knows the true value of the firms
assets and growth opportunities.
Outside investors can only guess these
values. If the manager offers to sell equity,
then the outside investor must ask why the
manager is willing to do so.
manager of an overvalued firm will be happy
to sell equity, while the manager of an
undervalued firm will not.
Adverse selection refers to a market process in
which undesired results occur when buyers
and sellers have asymmetric information
(access to different information); the "bad"
products or services are more likely to be
Adverse selection make some financing vehicles
much more expensive than others
Managers want to issue new stock only when it is
Stock issuance is a bad signal.
Stock issuance causes the price of outstanding
stock to fall.
Decline in stock price is part of the cost of
external finance.

Conclusion of adverse selection
Adverse selection models can be a
little mild. It is possible to construct
equilibrium with a pecking order, But
adverse selection does not imply that
pecking order as the general situation.

Agency theory
Principal-Agent Problem: Principal designates an
agent to act on his behalf. But because
monitoring and disciplining are costly, the agent
has scope to pursue his own interest at the
expense of the principal.
1. Separation of ownership from control allows managers
to use firm resources to pursue their own interests
rather than maximize shareholder value.
2. Separation of savers and investors allows investors to
use surplus funds to pursue their own interests rather
than accept the capital projects with the highest net
present value.

Debt Financing and Agency
One agency problem is that managers
can use corporate funds for non-value
maximizing purposes.
The use of financial leverage:
Bonds free cash flow.
Avoid bonuses and non-value adding
A second agency problem is the potential
for underinvestment.
Debt increases risk of financial distress.
Therefore, managers may avoid risky
projects even if they have positive NPVs.

Debt ratios vary among firms on the
basis of :

Determining Factors correlated with
Debt conservatism puzzle

Leverage Definition & Other
Econometric Issues

Leverage is defined as
i. Book leverage (debt/total assets) or
ii. Market leverage (debt/total assets + market value of
Early studies focused on book leverage
Debt is better supported by assets in place than growth
Market value fluctuates, so gives unreliable figures
Backward looking
Subsequent studies focused on market
leverage because
Book value only balance the two sides of balance sheet
Book value can be negative
Market value is forward looking

Econometric Issues
1. Panel structure of data
Can be overcome by using more than one methods
2. Incomplete data in panel
Can be overcome by multiple imputation
3. Outliers
Can overcome by rule of thumb (remove extreme
data), winsorization (most extreme tails of distribution
are replaced by most extreme value that has not been
removed) & robust regressions
4. Assumptions about debt market
Use of book debt to study debt market

1. Leverage & growth
2. Leverage & Firm size
3. Leverage & Tangibility of assets
4. Leverage & profitability
5. Leverage & industry median debt ratios
6. Leverage & dividends
7. Leverage & expected inflation
1. Leverage & Growth
i. Static trade-off theory predicts negative
correlation between these variables because of:
Underinvestment problem
Growth firms lose their value when are in distress
Asset substitution issue
In high growth firms, stockholders can easily increase project risk
Agency cost of free cash flow is less severe
ii. Pecking order theory predicts positive relation
between these variables
Different studies conclude negative correlation
between leverage & growth

2. Leverage & Firm size
i. Static trade-off theory predicts positive correlation
between variables because
Are more diversified
Low default risk
ii. Pecking order theory predicts negative correlation
between variables because
Adverse selection issue is low so equity issuance is
Studies find positive relationship between leverage
& firm size
3. Leverage & Tangibility of assets
Tangibility of assets is measured by:
Fixed Assets/ Total assets
i. Static tradeoff theory & Agency theory predicts
positive relation between variables because:
Easily collateralize-able
Difficult to replace high risk assets with low risk
ii. Pecking order theory predicts negative relation
Low information asymmetry makes equity issue less
Studies found positive relation between leverage &
tangibility of assets

4. Leverage & Profitability
i. Static trade off theory predicts positive relation
between variables because:
Bankruptcy cost is low
Tax shields are more valuable
ii. Pecking order theory predicts negative relation
Profitable firms prefer internal financing
Studies find negative relation between leverage &

5. Leverage & Industry median debt ratios
Different empirical studies find the positive relation
between variables
Firms adjust their ratios towards industry ratios


6. Leverage & Dividends
Static trade-off theory predicts positive relation as
high levered firms should pay more dividend to seem
less risky
Dynamic trade-off theory predicts negative relation
Pecking order theory predicts positive relation
Empirical studies show negative relation between
leverage & dividends

7. Leverage & Expected Inflation
Tax code suggests positive relation between
Tax deduction on debt is higher if expected inflation
rate is higher

Debt conservatism puzzle means that many firms are having
lower leverage than would maximize firm value
Miller find that bankruptcy cost is too small to offset large tax
subsidies of debt
He regarded tax gains & bankruptcy cost as horse & rabbit
stew recipe
i. Bankruptcy cost
Direct bankruptcy costs are less than indirect ones
Molina find that ex-ante cost of financial distress are
comparable to the current estimates of tax benefit of debt
ii. Tax Benefit
Information about tax shield is difficult to obtain
Graham & Tucker find that firms with tax shelters use less
debt but their results are criticized by different researchers

Ju et al (2004) find that firms have more leverage than
optimal ratio
Behaviorist approach find out that overconfident manager
chooses more debt than rational one

Tests of Pecking Order
Changes in debt have played an important role in
assessing pecking order theory because financing deficit
is suppose to drive debt
The regression of net debt issues on financing deficit has
slope equal to 1
Shyam-Saunders & Myers find a strong support for the
pecking order theory (0.75 regression slope)
Frank & Goyal (2003) found that equity is used more
than debt for financing deficit
This shows that other cross-sectional factors are more
important than financing deficit
Support for pecking order theory is found among large

Debt Capacity
Lemmon & Zender gave the idea of debt capacity in
understanding rejection of pecking order theory that when
constrained by debt capacity, firm issues equity otherwise
debt is issued
Firms with debt rating are unconstrained by debt capacity
Hhalov & Heider (2004) argues that in case of information
asymmetry, debt has more adverse selection problem
(asset volatility), so firms issue equity
Debt ratios donot rise prior to equity issues, suppotres
pecking order theory (Korrajczyk et al. 1990)
Less than 40% firms follow pecking order while issuing
debt where as almost half of the firms follow order while
issuing equity

Tests of Mean Reversion
Static trade-off theory predicts a debt ratio that depends upon
tax benefits & cost of financial distress (target adjustment
But data reveals that leverage is quite stable in American firms
Early studies used long term average as a target assuming
factors causing change are constant
Recent studies use two step procedure:
i. Target equation
ii. Adjusted equation
Different studies show that firms adjust towards target debt
But the speed with which adjustment towards target is made is
not a settled issue
Pattern of leverage changes are due to different adjustment
Leverage mean reversion happens through debt market
Previous literature & theories suggest that
Bankruptcy is the only way of exit
Mergers & acquisitions are more common reason for
exit than bankruptcy & liquidations
Exit by merger is different from exit by liquidation
In exit by merger & acquisitions, assets receive more
value than exit by liquidation

Effect Of Current Market Conditions On
Leverage Adjustment Choices
Factors affect leverage choices are
1. Market to book ratio
2. Inflation rate
But these two do not affect long term leverage ratio
Firms that issue equity in good markets have low
leverage ratio for a decade (Baker & Wurgler, 2002)
Different studies find that market timings have
effects on leverage but disappear after one 1-2
Effect of shocks on equity are permanent
This idea was rejected because usually good equity
returns are followed by more stock issues

Market Valuation of Leverage Changes

What are the Valuation effects on repurchases or
exchanges of one security for another?

Trade-off Theory:
Firms will only take actions if they expect benefits.
Market reaction to both equity and debt securities
will be positive

Two pieces of information confounding response to
leverage change:
i) The revelation of the fact that the firms conditions
have changed, necessitating financing.
ii) The effect of the financing on security valuations
Market Valuation of Leverage Changes
Good news if the firm is issuing securities to take
advantage of a promising new opportunity that was
not previously anticipated.
Bad news if the firm is issuing securities because
the firm actually needs more resources than
anticipated to conduct operations.

Agency Perspective:
Equity issues by firms with poor growth prospects
reflect agency problems between managers and
If this is the case, then stock prices would react
negatively to news of equity issues.
Market Valuation of Leverage Changes
Pecking Order Theory:
Predicts that securities with more adverse selection
(equity) will result in more negative market reaction.
Securities with less adverse selection (debt) will
result in less negative or no market reaction.
Eckbo and Masulis (1995)
Announcements of corporate debt issues and debt
repurchases have little if no effect on the market
value of the firm.
Announcements of equity issues are generally
associated with a drop in the market value of the
Announcements of equity repurchases are
generally associated with an increase in the market
value of the firm.
Market Valuation of Leverage Changes
Jung et al. (1996)
Firms without valuable investment opportunities
experience a more negative stock price reaction to
equity issues than do firms with better investment
Firms with low managerial ownership have worse
stock price reaction to new equity issue
announcements than do firms with high managerial
ownership (Agency view)
Eckbo and Masulis (1992)
Examined stock price reactions to equity issues
conditional on a firms choice of flotation method.
Announcements of security issues typically
generate a non-positive stock price reaction.
The valuation effects are the most negative for
common stock issues, slightly less negative for
convertible debt issues and least negative (zero) for
straight debt issues. The effects are more negative
the larger the issue.
Market Valuation of Leverage Changes
Natural Experiments

Blanchard et al. (1994)
Examined a sample of 11 firms and found that firms
increased their long-term debt following the cash
The pecking order predicts an increase in debt if
firms have attractive investment opportunities and
borrow more money.
The increase in debt following cash windfalls is
inconsistent with the pecking order theory.
The agency theories predict that managers expand
when possible.
Firms are able to increase debt because cash
windfalls increase a firms debt capacity.
Consistent with Agency theory.
Market Valuation of Leverage Changes
Natural Experiments

Cash can be viewed as negative debt, then, the
cash windfall is a reduction in leverage.
If the original leverage was optimal, then the firm
needs to increase its debt (or repurchase equity) in
response to the windfall.
Compatible with the trade-off theory perspective.

Experiments on Tax
Calomiris and Hubbard (1995) show that firms
increased their debt after the introduction of the
undistributed profits tax.
Consistent with firms increasing the amount of debt
to reduce taxes on retained profits.

Market Valuation of Leverage Changes
Natural Experiments

Experiments on Tax
In 1986, there was a tax reform that reduced both
corporate and personal marginal tax rates.
Firms with high tax rates prior to the tax reform
reduced their debt the most after the tax reform.
(Consistent with Trade-Off theory)
In 2003, there was a large cut in individual dividend
income taxes.
Chetty and Saez (2004) show that there was a
significant increase in dividend payments following
the tax cut.
Goyal et al. (2002) examine the US defense
industry during the 1980-1995 period.
Examined how the level and structure of corporate
debt changed when growth opportunities declined.

Market Valuation of Leverage Changes
Natural Experiments

Experiments on Tax
New debt issued increased significantly for
weapons manufacturers during the low growth
Dittmar (2004) and Mehrotra et al. (2003) examine
the capital structure choices that firms make when
engaging in spinoffs.
Firms with higher tangibility of assets are allocated
more leverage. Assets with lower liquidation costs
have more leverage.
Market Valuation of Leverage Changes

The most common criticism of survey approach is
that it measures beliefs rather than actions.
The approach implicitly assumes that managers
beliefs reflect reality.

Graham and Harvey (2001)
This desire for financial flexibility seems
inconsistent with the pecking order theory since
dividend-paying firms value flexibility the most.
Firms that perceive their stock to be undervalued
are reluctant to issue equity.
CFOs consider the tax advantages of debt to be
moderately important.

Market Valuation of Leverage Changes


Managers show great deal of concern about credit
ratings and earnings volatility in making debt

European managers also rank financial flexibility as
the most important factor in determining their firms
debt policy.

Tax advantage of interest expense ranked as the
fourth most important factor after financial flexibility,
credit rating and earnings volatility.
Conclusion/Stylized facts
According to the standard trade-off theory, taxes
and bankruptcy account for the corporate use of
According to the standard pecking order theory,
adverse selection accounts for the corporate use of
Private firms seem to use retained earnings and
bank debt heavily.
Small public firms make active use of equity
Large public firms primarily use retained earnings
and corporate bonds.
Direct transaction costs and indirect bankruptcy
costs appear to play important roles in a firms
choice of debt.
Over long periods of time, leverage [debt/assets] is
At the aggregate level capital expenditures are very
close to internal funds for large public firms.

Conclusion/Stylized facts
Firms adjust their debt frequently. The financing
deficit plays a role in these decisions.
Aggregate dividends are very smooth and almost
flat as a fraction of total assets for all classes of
After an IPO, equity issues are more important for
small firms than for large firms. Many small firms
issue equity fairly often.
Mergers and acquisitions are more common
reasons for exit than are bankruptcies and
Announcements of corporate debt issues and debt
repurchases have little if any effect on the market
value of the firm.
Announcements of equity issues are generally
associated with a drop in the market value of the
Conclusion/Stylized facts
Announcements of equity repurchases are
generally associated with an increase in the
market value of the firm.
The natural experiments papers are generally
easy to understand from the perspective of the
trade-off theory.

Thank You