Pecking Order Theory (Richa) Essay

1142 words - 5 pages

Pecking Order theory (richa)

* Gives the Reason why companies prefer to borrow less (profitable companies)
* This theory is based on the asymmetric information that managers know about the company than the outsiders. Investors, because of the lack of knowledge might be reluctant to invest in the company. Managers at times tends to be pessimistic and at times (rather genrally) they act optimistic.
* All of these problems are avoided if the company can finance with internal funds.
* But if external financing is required, issuing debt is preferred as the safest, as there is less scope of the debt to be misvalued.
* Hence,Pecking order theory is based on ...view middle of the document...

Agency costs arise because of core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders.
The costs consist of two main sources:
1. The costs inherently associated with using an agent (e.g., the risk that agents will use organizational resource for their own benefit) and
2. The costs of techniques used to mitigate the problems associated with using an agent (e.g., the costs of producing financial statements or the use of stock options to align executive interests to shareholder interests).

Overcome:
a. Compensation plans: common interest, stock price. Well-designed compensation scheme-encourage management to maximize shareholder wealth.
b. Performance related bonus
c. non-executive director: is a member of the board of directors of a company who does not form part of the executive management team. He or she is not an employee of the company or affiliated with it in any other way. They are differentiated from inside directors, who are members of the board who also serve or previously served as executive managers of the company (most often as corporate officers).
Free cash Flow hypothesis:
Mature firms with surplus of cash will tend to waste it. This contrast with standard finance theory, which says that firms with more cash than positive-investment opportunities should give the cash back to investors through higher dividends or share repurchases. One benefit of LBO(leverage buy out) is to put companies on a diet and force them to pay put cash to service debt. Free cash flow theory predicts that mature cash cow companies will be the most likely targets of LBOs.

Pecking order theory:
Theory that why profitable company borrow less, it is not because they have low target debts ratio but they don’t need outside money. On the other hand, less profitable company would issue debt first as they don’t have enough internal funds. It is based on asymmetric information-managers know more than outside investors about the profitability and prospects of the firms. As a result, investors may not be able to assess the true value of a new issue of securities by the firm. They might be afraid to buy new stocks, because the price could be overpriced. Because of this reason (optimistic manager...

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