Pecking Order Theory A Deep Dive — Transcript

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1. 0:00have you ever wondered how companies
2. 0:01decide on their financing strategies
3. 0:04what drives their decision to use
4. 0:05internal funds borrow or issue new
5. 0:08shares these intriguing questions find
6. 0:11answers in the pecking order Theory a
7. 0:13concept related to a company's capital
8. 0:15structure first proposed by Stuart Meers
9. 0:18and Nicholas maglu in 1984 the pecking
10. 0:21order Theory suggests that managers
11. 0:23follow a hierarchy when considering
12. 0:25sources of financing they prefer using
13. 0:28the company's retained earnings for
14. 0:30first then debt and finally they resort
15. 0:32to equity financing if necessary but why
16. 0:35this particular order the answer lies in
17. 0:38the concept of asymmetric information
18. 0:41this term refers to a situation where
19. 0:43one party holds more or better
20. 0:44information than another leading to an
21. 0:47imbalance in transaction power in the
22. 0:49corporate world managers often possess
23. 0:52more information about the company's
24. 0:54performance prospects and risks than
25. 0:57external stakeholders like creditors and
26. 0:59invest investors consequently these
27. 1:02external users demand a higher return to
28. 1:04counterbalance the risk they're taking
29. 1:06due to this information asymmetry now
30. 1:09the pecking order Theory starts to make
31. 1:11sense when a company uses its retained
32. 1:14earnings for financing it minimizes this
33. 1:16information asymmetry there are no
34. 1:18external parties involved and thus no
35. 1:21need for extra compensation due to the
36. 1:23risk of information imbalance this makes
37. 1:26internal financing the most convenient
38. 1:28and costeffective source of funding but
39. 1:31what happens when a company needs more
40. 1:32funds than its retained earnings can
41. 1:35provide that's when debt and Equity come
42. 1:37into play Managers generally prefer debt
43. 1:40over equity for a couple of reasons
44. 1:43firstly the cost of debt is usually
45. 1:45lower than the cost of equity secondly
46. 1:49issuing debt often signals confidence in
47. 1:51the company's prospects suggesting that
48. 1:53the board believes the investment will
49. 1:55be profitable in contrast issuing new
50. 1:58shares sends a negative signal
51. 2:01indicating that the stock may be
52. 2:03overvalued and that the company is
53. 2:05seeking to generate funds by diluting
54. 2:07ownership consider also the seniority of
55. 2:10claims to Assets in a bankruptcy
56. 2:12situation debt holders have a higher
57. 2:14claim to assets than stockholders so
58. 2:16they require a lower return this makes
59. 2:19debt a cheaper source of financing than
60. 2:21Equity so to recap the pecking order
61. 2:24Theory suggests that companies follow a
62. 2:26specific hierarchy when choosing
63. 2:28financing sources they start with
64. 2:30internal funds or retained earnings then
65. 2:33move to debt and finally resort to
66. 2:36equity if necessary this order arises
67. 2:38from the concept of asymmetric
68. 2:40information where the company's managers
69. 2:42hold more information than external
70. 2:44stakeholders leading to a preference for
71. 2:47financing sources that minimize this
72. 2:49informational imbalance it's a
73. 2:52fascinating insight into corporate
74. 2:53financing strategies shedding light on
75. 2:56the complex decisions companies make
76. 2:57every
77. 2:58day