How the Pecking Theory Applies to Start-ups Only - Essay Example

Topic: Detailed and critical analysis and discussion of how the Pecking Theory applies to start ups only and how this influences the entrepreneursdemand for finance. INTRODUCTION: Different companies have different methods of coming up with the much needed resources to keep the company's current business going. The different ways of generating cash inflows include revenues from operations, loans from banks and other lending institutions. One of the ways of generating cash inflows is to borrow money from the banks and other lending institutions. Another way is to offer its newly approved stocks to the public in the Stock exchanges. However, it seems that borrowing money under the Trade -off method is more in tune with the gearing ratio. The following paragraphs explain what is in the mind of the managers when they decide whether to use the Pecking Order Model or the Trade -off Model are used. BODY: MYERS' PECKING ORDER MODEL Myers (1984) stated that the company's managers have to exert all efforts to maintain the status quo in their dealings with the market. Thus, many the managers prefer to apply the pecking order theory than the trade off model in seeking additional funds to be used in their business operations (Scott, 1972;p. 45-50). The pecking order means that the company prioritises generating funds from internal sources. These internal sources include the net income or retained earnings from operations, dividend withheld from its stockholders (Baskin, 1989; pp. 26-35). If this choice is not possible, then the second source of income is borrowing money (Marsh, 1982; p. 121-144). The lenders become creditors and not owners of the company. If this second choice is also not possible, then the last choice would be to offer stocks to the public so that new investment money will flow in (Bradley, Jarrell and Kim, 1984;pp. 857-878). To reiterate, the pecking order is the preferred choice of many managers because they do not want to go through the rigours of having to place themselves under the scrutiny and investigative discipline the law when money is borrowed such as the banks request for a feasibility study to determine if the company will be able to pay their loans when the due date arrives (Ferri and Jones, 1979;pp. 631-644). Likewise, the company will not have to go through the difficulty of submitting to the stock exchanges and the government regulating agencies the reasons for their planned offering of stocks to the market (Mikkelson and Partch, 1986;p.31-60). But in this occurs, then the company would rather offer preferred stocks before offering the common stocks the public. For the common stock gives the investors the right to vote in the management's business plans. Whereas, most preferred stocks do not permit the stockholders to vote in the management plans. For, many managers abhor the presenting of confidential financial statements to the lenders and general public when stocks are offered in the exchanges (Myers and Majluf, 1984; p. 187-221). For, the pecking order shows that generating funds associates the gearing ratio to the company's retained earnings which is the accumulation of the yearly net income of the company and distribution or withholding of dividends to the stockholders on record and the offer of stocks to the general public in stock exchanges (Jalivland and Harris, 1984;p.127-145). Reasonably, management will prefer to pay dividends to their stockholders and expand its business operations through additional investment from its current stockholders on record instead of offering new stocks to the general public who are complete strangers to the company (Taggart,1977;p.1467-1484). For, internally generated money will do away with the usual problems and obstacles when external money is chosen as a fund source. Furthermore, externally -generated funds like bonds and long term bank loans could place an additional requirement that all company business decisions in terms of expansion or closing down shop will have to be approved by the bank lender or the bond lenders. In addition, the company does not have to reduce the price of each stock when money will come from stocks offered in the stock exchanges. However, the company's withholding of dividend payouts to its stockholders in order to funnel back the dividend money into operations instead of borrowing money would not look good in the eyes of the current investors. Obviously, the pecking order model shows that borrowing money is the second choice and that offering stock to the public through the stock exchanges is relegated to third choice because management does not want new stockholders to meddle in the already complex management structure in terms of business expansions, closing shop or buying high dollar equipments and the like (Donaldson, 1961). Obviously, the pecking order model states that the company does not need to issue new shares of stocks to the general public if it can apply for a bank loan or issue bonds which are instruments of debt. The Pecking Order Model states that financial gearing represents the cash flows coming from the company itself, the dividend payout ratio and the investments. For, financial gearing, investments, dividends and earnings are influenced by each another. The formula is FG = f(Earnings, Dividends, Investments). Also, the pecking order formula is: NE= Div + CE + WC + Dif Where: Dif = NE -(Div + CE + WC) For: NE = Earnings before interest expense and taxes Div = Dividends CE = Capital Expenditures WC = Working Capital Change Dif = Difference which is positive (surplus) or negative (deficit) The theory concludes that the company can retires its loans because of oversupply of funds if Dif > 0 i.e., NE> Div + CE + WC. On the other hand, the company will have to borrow money from banks, etc. because it has a shortage of cash as shown in the company's balance sheet if Dif < 0. TRADE -OFF MODEL The trade -off model basically shows that many companies prefer to revise their leverage level towards an optimum proportion (Shyam-Sunder and Myers, 1999;p219-244). And, this optimum ration includes a trade -off of some sort. For example, one possible trade -off could be an increase in tax benefits when gearing is increased and the increase in agency and bankruptcy expenses (Kwansa and Cho, 1995; p. 339-350) that is the offshoot of an increase in loan amounts (Ashton, 1989; pp. 207-212). For, actual loan percentages will be revised through the influence of gearing. For, the optimum gearing level is a fifty: fifty ratio. Meaning, the total outstanding loans should be $100,000 if the company equity is $100,000. Thus, the company must try to generate this ratio as soon as possible. For, going into business within borrowing money at this ratio shows that the company lacks the fifty percent loan needed to increase production and expansion activities so that sales will double or even triple in order to increase the net profits of the company (DeAngelo and Masuli, 1980;pp. 3-29). Likewise, borrowing money would be very difficult because the lending institutions like the banks need an audited balance sheet that the company has assets bought through the used of Equity (Balakrishnan and Fox, 1993; pp.3-16). For, the lenders will use the assets and the equity of the company as collateral to assure that the company will be able to pay their loans when the due date arrives Myers, 1984; p. 575-592). Thus, a fifty percent loan plus a fifty percent equity will equal to a one hundred percent total assets that will be used to maximize profits and as a collateral to pay the loans when the loan repayment date arrives. One good reason favoring the trade -off model is that cash inflow coming from loans do not generate taxes whereas cash inflow coming from net income is first deducted the required forty percent (40%) tax amount (Dammon and Senbet, 1988;pp.357-373). In addition, many companies prefer to sign short term loan agreements as compared to long term debt contracts. Thus, this is the middle ground between the Pecking Order model and the Trade -off model because the company enters only into a debt contracts as choice number 2 in the Pecking Order model (Griner and Gordon, 1995;p.179-197). Also, this short term loan fulfills the requirement of the Trade -off model but the interest expense will be lesser than when the loan agreement entails five, ten or even twenty years. For, short term loans are the trademark of companies that are flexible and financial strong (Jun, 2003; p. 5-34). Further, there are is a clear dividing line between the Pecking Order Model and the Trade -off Model. For one, many Pecking Order Model company companies that have lesser investments pay higher dividends and more frequently than companies that withhold their dividends (Norton, 1991;p.287-303). Also, the Pecking Order Model company are more profitable because they do not leverage their business and thus save on interest expenses paid out to the banks and other lenders (Opler and Titman, 1993; p.1985-1999). Advantageously, the Pecking Order Model company is more at an advantage in terms of saving on interest expenses on money borrowed ( Adedeji, 1998; p 1127-1155). CONCLUSION: There are two popular ways of generating funds when a business is just starting up. The first method is the Myer's Pecking Order Model and the second is the Trade -off Model. The first model prioritizes generating cash inflows first from internal earnings and dividends. Next, the company can apply for a loan from the bank to fill its cash needs. Third, the company can issue new shares of stocks to the public in order to generate as much money as possible. Of the two methods, Pecking Order Model is better than the Trade -off Model because the Trade -Off model involves paying interest to the lender of the money. However, the gearing ratio shows that the company must use a 50% debt and a 50% equity to maximise company profits. CONCLUSIVELY, both finance models have their advantages and disadvantages placing them on equal scorecards. REFERENCES: Adedeji, A.(1998), Does the Pecking Order Hypothesis Explain the Dividend Payout Ratios of Firms in the UK, Journal of Business Finance and Accounting, Vol. 25, No. 9, pp.1127-1155. Ashton, D., (1989), Textbook Formulae and UK Taxation: Modigliani and Miller Revisited, Accounting and Business Research, Vol. 19, No. 1, pp. 207-212. Balakrishnan, S., Fox, I.,(1993). Asset Specificity, Firm Heterogeneity and Capital Structure, Strategic Management Journal, Vol. 14, No. 1, p. 3-16.l Baskin, J., (1989). 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