The awareness of cash flow investment sensitivity dates back to the late 1950s and its debate was largely stimulated by the seminal work of Modigliani and Miller (1958) on capital structure and investment decisions which stated that under perfect capital markets conditions, there is no capital rationing; external financing can be accessed without any friction. They argued that, under these conditions, investment decisions are independent of the firm’s financial status;
that is its liquidity, leverage and dividend policy. When there is no capital rationing, the availability of internal funds should not affect the firm’s investment, as internal and external finance are perfect substitutes. This proposition implies that the firm’s growth rate and capacity to undertake fixed capital investment should only be influenced by its expected future profitability.
Under imperfect capital market conditions, information asymmetry and the agency problem play a key role in allocating resources for firms and when they increase, financial constraints also increase (Kassim and Menon, 2003, Lin and Huang, 2011). Market frictions like issuing costs, agency costs and information asymmetry make external finance more costly than internal finance. These drive a wedge between the costs of internal resources and external capital (Myers, 1984). The Pecking Order Theory is premised on the logic that internal resources have a
“cost advantage” over funds raised externally (Cleary, 1999). The transaction costs of issuing debt and equity which include underwriting fees, registration fees, taxes and accounting fees can be substantial, making it expensive to depend on external finance. Underwriting fees generally constitute the single largest direct cost element of issuing securities and can be as high as 2.5% of the amount to be raised (Firer et al., 2012).
External funds are less desirable because they tend to be underpriced in relation to the asymmetry level; for example, they decrease the price of new bonds to be issued. External
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funds send signals to the market; new bond issues tend to send positive signals. New equity issues tend to send negative signals about the company; they signal that the company has too much debt or little liquidity (Firer et al., 2012). Two South African studies found that the share price decline as a result of new equity issues announcements was within the range of 2.0% to 3.5% (Bhana, 1998, Youds et al., 1993).
Information asymmetries and agency costs potentially cause either underinvestment or overinvestment (Baños-Caballero et al., 2009). The conflict between shareholders and bondholders (the agency costs problem) stems from the limited liability of shareholders and the priority of creditors in event of bankruptcy impacts on the cost of external funds. Shareholders’
limited liability might induce them to undertake more risky investment projects since they gain from the firm’s higher value (as a result of high risk investments) at the expense of creditors who might incur possible losses (Jensen and Meckling, 1976). In contrast, creditors’ preference in the event of liquidation may force shareholders to abandon profitable projects with positive NPVs when the NPV of the investment is less than the amount of debt issued. As a result, firms have to pay a risk premium, resulting in external funds being more expensive. According to Bernanke and Gertler (1989) the quality of the firm’s balance sheet influences the agency costs of external finance. When its liquidity decreases or when the prospects of future sales deteriorate, the cost of external finance rises.
Information asymmetry indicates that insiders (managers) know more, are assumed to know more or have all the information concerning the future performance of the firm’s investment prospects and value, than investors (Myers and Majluf, 1984). Although investors/outsiders may have correct perception about the investment potential of a population of firms, they cannot differentiate good projects from bad projects or the quality of individual firms. Since outsiders do not have full information on the individual firm or its projects, when new securities are issued, they discount them, assuming the average project outcome in order to ensure that they do not invest in overpriced securities. This results in the underpricing of securities, including those backing good projects. Given this undervaluation, the cost of externally-funded
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projects is higher than the cost of internally-funding project. Outsiders may demand a discount that is so large that management may find it more economic not to issue securities and abandon the investment instead. This supports the argument that informational asymmetries may induce financial market inefficiencies that spill over to the real side of the economy.
Therefore information asymmetries make it more difficult to raise external funds and increase the costs of such funds, making internal financing preferable to external financing.
In the credit market, information asymmetries between firms and investors in competitive markets create adverse selection and moral hazard challenges; causing lenders to ration credit (resulting in its availability at a high cost/premium) (Stiglitz and Weiss, 1981).
Modern financial and economic theories and empirical evidence concur that real investment may be influenced by financial factors such as internal resources availability, the accessibility of external finance from financial markets and financing costs, among other factors. Internal resources and external capital are not substitutes; firms may prefer internal funds over external funds because they are cheaper. This view is supported by several previous studies (Fazzari et al., 1988, Cleary, 1999, Moyen, 2004).
Firms are unable to exploit arising investment opportunities when they have insufficient internal liquid resources and the “perishable” nature of projects means that the liquidity position of a company significantly impacts on its ability to undertake investment projects (Boyle and Guthrie, 2003).
The Pecking Order Theory has been widely used to explain the financing preferences of managers in contemporary financial management. The theory states that managers follow a hierarchical pattern of financing sources where they first rely on internal finance when available; and external funds are used only when internal resources are exhausted. In terms of external funds, debt is preferred to external equity.
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The Pecking Order Theory has three main implications. First, the firm’s capital structure is determined by its need for outside finance, which dictates the amount of debt the firm will have. Therefore, firms have no optimal capital structure. Second, profitable companies have more internally generated resources; therefore they have less need for external funding.
According to Firer et al. (2012), empirical evidence on capital structure seems to support this conclusion. Third, companies build a cash reservoir, financial slack, which they draw on to finance new projects as they emerge.