Essay Sample on External Financing: Pecking Order Theory & Stable Revenue

Introduction

The financing of several firms is from the external, a behavior which many people do not like as internal finance is more reliable than external. The pecking order theory of capital structure is taken as an effective tool of leveraging revenues in the organization to ensure that internal supply of finances is stable Murray, (Frank, Vidhan & Goyal, 2002). The theory obtains its influence from a view that most of the finances of a company from the external plays a very small role than the internal. It advocates for internal financing where, where, the financing behavior of the organization is driven by adverse selection costs.

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When comparing equity debt and retained earnings, the pecking order theory would advocate for retained earnings. This is because, equity and debt has adverse selection costs where equity is higher. Investors to the organization would expect the high rates of return which would constrain the organization. In this analysis, it is proven that the pecking order theory is better than the conventional leverage regression. Debt financing will never dominate equity financing and retained earnings are never enough to finance the entire organizational needs which are treated as exogenous.

The pecking order theory applies more to large firms with high financial basis where debt will not be a factor. Access to external sources is not a problem and therefore due to high economies of scale. Unlike the regression leveraging this would apply to small firms where equity debts will be a problem. These firms are taken to have future growth opportunities due to their high opportunities. The diversification of their portfolios is what contributes to their large financial basis. This is backed up by the tradeoff theory which has it that profitable firms should have higher leverage so as to offset corporate taxes.

A Study on Financial Constraints of Capital Structure Theories and Dividend Policy: Evidence from Indian Capital Market

India records small economic changes since the reformation it had since 1990. The country records a GDP growth of 7% since 1990 to 2008. This success can be attributed to the reforms made in which the government introduced privatization of companies. The research done tests the hypothesis that capital structure and the dividends policy impacts on the financial performance of the country significantly. The findings follows the structure that the financial performance is affected by other factors like taxation and macro-economic conditions.

There is a weak relationship between the dividends policy payout and the retained earnings of the organization. Inversely, the relationship between the dividends policy and the leverage is strong (Sreenu, 2015). It is backed up by the pecking order theory that indicates that internal financing is not sufficient for internal activities. The study indicates that the dividend policy applies to large firms since, large firms have a higher dividend ratios to the shareholders and therefore are bound to work harder. This is because the amounts of dividends being paid out, correspond to the efficiency in which firms run their activities.

The regression analysis done gives a ten percent significance level on variances inflation factor which is the dependent variable while the DIRS has a null hypothesis of five percent significance level. Therefore, the result is not consistent with the null hypothesis which renders the alternative hypothesis to be true. Capital structure and dividends policy is not sufficient in determine the financial success of a country or corporation.

Examining Pecking Order Versus Tradeoff Theories of Capital Structure: New Evidence From Japanese Firms

The study looks at the traditional tradeoffs against the pecking order model of capital structure with data from the Japanese countries. This follows the fact that the financial structure of the Japanese has been through indirect banking. It contributes to large borrowing over a long period to the client firms. The study uses generalized methods of moments (GM) which would overcome endogeneity, autocorrelation and heteroscedasticity.

The relationship between leverage and profitability of a firm is found to be negative with a record of one percent significance level. The pecking order is favored over the trade-off model where, there is a significant difference between internal cost financing and the external. Firms in most cases would choose debt over equity, a conclusion which is in correspondents with the pecking order theory (Jarallah, Saleh & Salim, 2018). This is because; equity has higher costs than debts due to the demands from the investors. It explains the reasons why the firms in Japan would go for indirect naming as a source of finances than sales of shares to investors in gathering of equity.

Therefore, internal financing is not a reliable and sufficient method of ensuring financial growth and stability in the firm. Firms depend on the external factors but the hard question comes in comparing use of equity and debts. The cost of equity is however, higher compared t suing debts. This explains why most firms especially the small firms would opt using debt rather than equity. Equity is however, efficient in large firms that are ale to raise enough profits to pay ff dividents to its shareholders.

References

Frank, M. Z., & Goyal, V. K. (2002). Testing The Pecking Order Theory Of Capital Structure. Journal of financial economics, 67(2), 217-248.

Jarallah, S., Saleh, A. S., & Salim, R. (2019). Examining pecking order versus tradeoff theories of capital structure: N ew evidence from J apanese firms. International Journal of Finance & Economics, 24(1), 204-211.

Sreenu, N. (2019). Financial Management Practices of Indian Small and Medium Enterprises (SME): A Study of Food Processing Sector. ITIHAS-The Journal of Indian Management, 9(1).