Pecking Order versus Trade Off Theories

Theories on How Companies Deal With Debt and Financial Distress

Companies can use two popular theories to conceptualize their capital structure. Pecking Order (POT) and Trade-Off (TOT) are always used interchangeably when proving organizations are seeking to ease their way of making capital structure decisions. The following study elucidates the differences between the two theories.

The Pecking Order vs. Trade-Off

The Trade-Off Theory refers to the concept that a company chooses how much equity finance and how much debt finance to use through balancing the benefits and costs (Agarwal, 2013). This theory explains that organizations are often financed partly with equity and partly with debt. Pecking Order Theory argues that the cost of financing increases with asymmetric data. There are three sources of financing for a company: internal funds, new and debt equity. Firms prioritize their financing sources. First, they prefer preferring internal financing, and then debt, lastly equity is used as the last resort. This implies they use internal financing first when this is depleted; they use debt, and when it is no more sensible to solicit debt, they turn to equity (Puntaier, 2010).

The TOT addresses the limitations seen as inconsistent with the advantage behavior provided some level of information (Agarwal, 2013). This theory postulates that organizations would naturally finance new investments using debts as against equity; first to trade-off tax liabilities and then second to cause some level of scarcity on the stock as a means of increasing a company's worth. However, opponents of the TOT claim that it failed to explain the cause of a decline in stock prices as seen when companies announce new issues. The ensuing discussion evidence that debt financing correlated to periods in positive direction especially about economic boom and rates. Conversely, the POT disagrees on the degree of simplicity postulated by the TOT. POT explains that the availability of unequal data and the projected cost of bankruptcy or distress will adversely affect managers' choice of financing (Parrino, 2011). The concluding consideration of the POT is that companies are most likely to issue equity following a share price increase. This is explained by the fact that if there were a fixed target leverage ratio, companies would prefer to issue debts.

Specific Businesses Following the Trade-Off Theory and the Pecking-Order Theory

Coca-Cola uses debt when financing its operations. The company maintains debt levels, which they consider prudent depending on interest coverage ratio, cash flows and percentage of debt to capital (Parrino, 2011). This approach benefits the company because it allows them to lower their overall cost of capital thus increasing their return on shareholder's equity. Coke's debt management strategies, in combination with their share purchase policies and an investment activity results in current liabilities surpassing current assets. Payments and issuances of debt include both long- and short-term financing activities. For example, as of 2013, Coke had $2,100 million in lines of credit and other short-term credit facilities available, of which roughly $270 million was outstanding (Agarwal, 2013). Primarily, Coke's outstanding amount of $270 million was associated with its global operations.

Walmart is a leading mass merchandiser and the world's largest retailer. It has penetrated over twenty-seven nations with over 12,000 stores worldwide. Walmart uses a mix of both debt and equity (optimal structure) to raise capital (Puntaier, 2010). The company uses this approach to capitalize on the strengths of both TOT and POT models. Usually, debt costs less than equity because of tax advantages, particularly when rates are low (Puntaier, 2010). In comparison, equity does not need to be paid back although it comes with an exchange of ownership. It is the goal of Walmart to operate at an optimal capital structure to maximize profits.

Applicability of the Theories in Various Some Industries

We should not look at these theories as conflicting but as complementary. The conflicting nature of the POT is attributable to the difference between the financing practices of small and large firms. POT performs poorly for small companies because they hold low debt capacities, which are easily exhausted, compelling them to issue equity. POT works well for large companies and those with high debt rates. It can also be used when the company's debt capacity is proven as manageable (Baker & Martin, 2011).

In this sense, POT is unlikely to perform well for firms investing into intangible assets. The TOT works appropriately within industries that have room for growth and expansion. Mature sectors, which can practically project their future, such as Coca-Cola are unlikely to incur any losses by using external funding. For instance, as of 2014, Coke has a long-term debt of $20,000 million with a net income of $50,000 million (Agarwal, 2013). For the company, the debt ratio is optimal and maximizing its market capitalization value within their manageable debt levels. Coke has a long-term debt of less than a year's current net income. Therefore, a single year earnings could be used to settle the debt.

As for Intel, it adheres to the POT, especially because of its high-risk industry. Though the firm is large, factoring that the technology is constantly evolving, Intel struggles to remain relevant. This renders the sector to be high risk. Due to the fierce competition and large market, Intel must produce innovative items and quickly get them to the market. This leads to a problem by not allowing revenue to fund Intel's growth, and they have to depend on debt to satisfy the market (Baker & Martin, 2011).

Conclusion

Overall, the controversy over capital structure is unlikely to be addressed concerning the predominance of these theories prevailing over the others. As such, it is important for a company to weigh the advantages and disadvantages of each model before making a choice. In this sense, the existence of multiple capital structure theories, as opposed to one, tend to be beneficial.

References

Agarwal, Y. (2013). Capital Structure Decisions: Evaluating Risk and Uncertainty. New York: Wiley.

Baker, H. K., & Martin, G. S. (2011). Capital Structure And Corporate Financing Decisions: Theory, Evidence, and Practice. Hoboken, N.J: Wiley.

Parrino, R. (2011). Fundamentals of Corporate Finance. Hoboken, N.J: Wiley.

Puntaier, E. (2010). Capital Structure and Profitability: S&P 500 Enterprises in Light of the 2008 Financial Crisis. Hamburg: Diplomica-Verl.