Wednesday, November 10, 2004

The Pecking Order--Dead or Alive?


What a treat we have! It is by Colin Mayer and Oren Sussman. It is on the pecking order.

The last we visited the pecking order was January's FinanceProfessor.com newsletter:
Myers and Majuf's famous 1984 pecking order hypothesis attempts to describe how firms raise capital. The authors hypothesized that firms are driven by information asymmetries and transaction costs to use internally generated capital first before turning to more expensive sources of financing. Once
their internal sources are used, then firms will use debt (where the information asymmetry problem is less severe) first and then as a last resort will use equity.
Not surprisingly many researchers have investigated this hypothesis. For example, two recent papers have taken different tacks, but have each come to the same basic conclusion, namely that the pecking order hypothesis does not fit the evidence. The papers are (1) by Fama and French and (2) by Galpin. In brief, recent work has suggested that the pecking order is in trouble and as I concluded the piece in January by writing: "currently the pecking order does not work" camp has the momentum."

Well we may have a "momentum changer"!

Mayer and Sussman look at the pecking order by examining firm behavior around spending "spikes" and find that is does help explain firm finance activity, at least in the short run.

The logic behind there study is relatively simple but important: generally the firms ability to generate cash is at least as as its ability to find positive spending opportunities. Thus, internally generated cash is most often used. However, when there is a large expenditure, this changes and the firm must rely on external financing.

In the words of the authors:
"Most investments are thus undertaken by financially unconstrained firms that shed little light on the main body of corporate finance theory, which is developed on the assumption that firms are financially constrained. Indeed, most theoretical corporate finance relates to the financing of indivisible investment opportunities, i.e. projects undertaken by cash-poor entrepreneurs and companies.
So rather than look at all firms, look at those that may be "cash poor," hence firms making large investments. When this is done, the results change!

"We find that the spikes are predominantly financed with debt by large firms and by new equity by small loss-making firms."
Which is consistent with the pecking order!

Equally interestingly, however, the authors find evidence that firms do have some target capital structure in place and that managers do consider this as an optimal financing mix and try to return to it once the investment spike is financed.


There is clear evidence of capital structures reverting back to previous levels of leverage after an investment spike. The size of adjustments is very significant: large firms offset up to 70% of the disturbance to their capital structure over a five year period around the investment spikes.
So what does this all mean? It seems to point to a world where both the pecking order and the trade-off model have something to offer us. As Mayer and Sussman summarize:
"The pecking order provides a partial but not wholly accurate description of firms' behaviour in the short run while the trade-off theory holds in the long run. Neither the pecking order nor the trade-off theories on their own therefore are adequate descriptions of the data."
This paper is to be presented at the American Finance Association's (AFA) annual meeting which takes place in January. Be sure to look for it! You will like it!

This paper is also available through FEN.

1 comment:

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Groetjes Albert