Critically assess the Pecking Order Theory of Capital Structure

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There is no universal theory of the debt-equity choice, and no reason to expect one. In this essay I will critically assess the Pecking Order Theory of capital structure with reference and comparison of publicly listed companies. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. This theory explains why firms prefer internal rather than external financing which is due to adverse selection, asymmetry of information, and agency costs (Frank & Goyal, 2003). The trade-off theory comes from the pecking order theory it is an unintentional outcome of companies following the pecking-order theory. This explains that firms strive to achieve an optimal capital structure by using a mixture debt and equity known to act as an advantage leverage. Modigliani and Miller (1958) showed that the decisions firms make when choosing between debt and equity financing has no material effects on the value of the firm or on the cost or availability of capital. They assumed perfect and frictionless capital markets, in which financial innovation would quickly extinguish any deviation from their predicted equilibrium. The pecking order theory suggests that firms have a particular preference order for capitalised to finance their businesses. Stewart Myers put forward the idea of pecking order theory in 1984 in which mangers will prefer to use retained earnings first and will issue new equity only as a last resort (Book Reference). Companies prioritize their sources of financing according to the principle of least effort, preferring to raise equity as a financing means of last resort. Wang & Lin (2010) how internal funds are used before debt and once thi... ... middle of paper ... ... Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297. Moore, R.R. 1993, "Asymmetric Information, Repeated Lending, and Capital Structure", Journal of Money, Credit and Banking, vol. 25, no. 3, pp. 393-409. Myers, S.C. 2001, "Capital Structure", The Journal of Economic Perspectives, vol. 15, no. 2, pp. 81-102. MYERS, S.C. and MAJLUF, N.S., 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), pp. 187-221. Nicholls-Nixon, CL 2005, 'Rapid growth and high performance: The entrepreneur's "impossible dream?"', Academy Of Management Executive, 19, 1, pp. 77-89, Health Business Elite. Wang, K.A. & Lin, C.A. 2010, "PECKING-ORDER THEORY REVISITED: THE ROLE OF AGENCY COST", Manchester School, vol. 78, no. 5, pp. 395.

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