CHAPTER 1: INTRODUCTION
1.1 Introduction
The purpose of this research is to evaluate whether pecking order exist in the Kuala Lumpur Stock Exchange(klse).Various capital structure theories have been put forward through the years, with the most noted being Modigliani-Miller(1958), to clarify, how firms raise funds for their demand, how other firms are in more debt than others or favour different means of finance, how firms ought to finance their demand , the dynamic standards of managers and shareholders. This theories have given birth to other new theories. All this theories in actual fact can be divided into three sets(Åžen and Oruc,2008), clarifying the formation of capital structure. The three groups are Trade-off theory, Agency theory and Pecking Order.
Myers(1984)' Trade-off theory states that there should be a balance between tax saving as result from debt, decrease in agent cost and bankruptcy, financial distress. The theory further states that, this is so because firms cannot achieve value maximization when they outline a capital structure based solely on external resources or excluding such resources. Ghosh and Cai (2001) go on to point out that in line with the trade-off theory, a balance between costs has to be achieved by firms to attain an optimal capital structure. Agency theory, alternatively known as the principal-agency problem is a collection of ideas on possible conflict of interests between managers(principals) and shareholders(agents), and how firms try to evade such conflicts. The theory argues that two agency problems arise when there is asymmetry or unequal information to all, and uncertainty: adverse selection and moral hazard. Adverse selection occurs when shareholders are not sure if managers are carrying out their duties diligently reflecting their pay. Moral hazard occurs when the share holders are not certain that the agent is putting its maximum effort in its duties (Eisenhardt, 1989). Mitigating this situation brings about agency costs. Jensen and Meckling(1976), suggest tying the agent's remuneration to the firms performance to solve this issue.
This report will evaluate the relevance of Pecking order theory in capital structure decisions of Malaysian firms on the Bursa Malaysia. The theory will be discussed in the literature review
1.2 Definition of key terms
Pecking order: Under pecking order managers prefer to use internally generated funds(e.g. retained earnings) first, followed by debt and to avoid issues until other resources have been exhausted. The Pecking Order Theory or Pecking Order Model was developed by Stewart C. Myers and Nicolas Majluf in 1984. It states that companies prioritize their sources of financing (from internal financing to equity) according to the Principle of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued.( Pecking Order Theory. wikipedia)
Capital structure: capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.
1.3 What is capital structure?
Capital structure can be defined as the amount of permanent short-term debt, long-term debt, preferred stock, and common equity used to finance the firm. Permanent short term is contrasted with seasonal short-term debt. In contrast, financial structure is the amount of total liabilities, long term debt, preferred stock, and common equity used to finance the firm. To sum the above definitions capital structure is part of the financial structure, representing the permanent sources of financing the firm. Capital structure analysis emphasis the capital structure the firm wants to eventually operate at in the future, that is, target capital structure. It's usually easy to calculate the target structure of most firms, as their current and target structures are the same. However there are cases where a firm, find the need to modify their capital structure to a new target. Reasons for such a change vary from an increase in competition that may increase risk or change in the company's asset mix(the combination of the firm's debt and equity value.
1.4 Capital structure theories
Capital structure theories are premises that intertwine with capital structure decisions and suggest practices to maximize shareholder value.
Capital investment analysis can be traced back to 1951, in Joel Dean's Managerial Economics(1). Dean's model classified capital projects into four categories, each with a different hurdle rate reflecting its risk, and also stated that each investment should have a hurdle rate that relates to its own risk characteristics. Ever since then conceptual guidelines for capital structure decisions have followed a similar path. The guidelines basically distanced themselves from focusing on managerial judgment to a firm recommendation of proper balance in selecting the proper balance between debt and equity. Gordon Donaldson (1961)later published his monograph, and it was seen as restoring decisions about capital structure to financial officers. He suggested that the critical variables were not balanced sheet or coverage ratios but the ability of the firm to service obligations from operating cash flow in adverse conditions. The most
Notable and powerful article to be published in this area, was by Franco Modigliani and Merton Miller(MM), which simply stated that given certain assumptions(perfect information for all, equal access to infinite and investments no tax or transactional costs and that all decision makers were value maximizes), the value of the firm does not vary with its capital structure. In 1963, Modigliani and Miller had modified the conclusion to recognize tax shield, under the consideration of tax shield .MM's conclusion was that companies should use debt as possible to maximize value.
Stewart C. Myers(1984) suggested an alternative approach to management behaviour, and it was in the form of 'pecking order'. Under pecking order managers prefer to use internally generated funds(e.g. retained earnings) first, followed by debt and to avoid issues until other resources have been exhausted. The reason for preference of internally generated funds is that it involves little risk of mispricing caused by imbalanced information. When earnings are volatile and requirements for capital investments are uneven, pecking order holds that the firm will save funds or restore borrowing capacity when enjoying cash surplus and will draw funds when the cash flow is negative. According to pecking order, once the surplus funds are gone, firms turn to simple types of debts first, as they are the less risky way of obtaining external funds. This is followed by junior securities like high yield debt or convertible preferred stock, and common stock come last. This conceptualization implies that the reason highly profitable firms do not borrow is that they do without the cash, as they can raise their own internally. Less profitable firms however have no choice but to source funds externally(debt) in order to benefit of attractive investments. As much as the above account points to inviting leverage buyouts and avoid capital market discipline, it can be countered by pointing out that pecking order approach has rational economic support. A prime example is managers of cyclical industries. They know that their firms will face tough periods as well as good ones during the cycle, where cash flows will vary accordingly. Firms with costs in mind follow the pecking order as a means of keeping costs as low as possible over the longer term.
According to MM company tax is a reason for preferring debt to equity, even though they suggested its fundamental irrelevance to financial decisions of the firm.( Modigliani and Miller, 1958). In their argument which is bound by perfect markets, value of a permanently leveraged firm is generated by adding the value of the corporate tax shield of debt to the value of an identical but unleveraged company (Modigliani and Miller,1963). Miller went on to develop a broader outlook on tax incentive by integrating personal tax into the model.
1.5 Pecking order theory
Pecking order theory was originally started by Donaldson(1961), as a account of financing practice. Myers(1984) explains it as the hierarchy followed by management in choosing financing for the firm. Modigliani-Miller (1963-1958) point out that in the existence of efficient markets, hence all parties have the same access to all information, there would be no asymmetry. The theory states that pecking order theory is born from the existence of information asymmetry in firms, as markets are not efficient in the real world. As a result of this firms prefer internal funds to external financing, and if external funds are to be used, debt is preferred over equity. Debt is favoured over equity due to information costs associated with debt issues.
Myers and Majluf (1984) go on to argue that information asymmetry can be totally solved by only using retained earnings as a source of finance and not issuing any other securities. For this (internal financing) to happen, the firm should have or retain enough cash, marketable securities and unutilised(unused) free debt capacity.¹
Reasons for this hierarchy in this three sources of funding(retained earnings, debt and equity) to a firm, are as follows. Equity is plagued more by adverse selection problems compared to debt with has trivial adverse selection problems. In general it is thought that firm management possess an advantage of information over stock investors or market, on potential investments and profits(information asymmetry). For instance if a firm plans on expanding its operations and finances this equity, the investors will not know fully the value of the stocks right then(Myers, 2001). Due to information asymmetry, investors will undervalue the stocks (Halov and Heider,2005), therefore since managers are expecting investors to pay a discount for the stocks, they will prefer utilising retained earnings or internal resources which do not have adverse selection problems, first, followed by debt which as stated has a low risk potential (Fama and French, 2002).
Position of organisational sales also play a part in considering debt over equity. As its common knowledge lenders prefer clients who are trustworthy and more likely to pay their debts. Therefore firms with stable sales can easily acquire debt resources, as they are less likely to default on their debt. Such firms would prefer debt over equity because of the potential easiness of acquiring such resources. Another reason for the preference of debt is the tax advantage of debt. The debt's interest rate is discountable from the tax base. Another reason is avoiding transaction cost associated with issuing stocks(Fama and French,2004), such as placing an issue with the issue house(investment bank),under writing costs etc. Debt is also desired over equity is the size and the structure of the firms. Bigger firms can easily borrow as they have more assets to use a collateral.
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¹ Debt capacity is the to the total of funding a firm can borrow, before its financial stability is jeopardised. The debt coverage ratio is usually used to measure debt capacity. Therefore unused free debt capacity is simply the unutilised potion of debt capacity. An example may be found in overfunded pension plans.
1.6 Methodology
1.7 Problem Statement
The purpose of this research is to find out or test whether pecking order exist in the Malaysian Stock Exchange((Bursa Malaysia), by studying financial statements, particularly the debt and its determinants, of 90 firms from the nine Industries in the Bursa Malaysia from 2004-2008.
1.8 Research Question
The research questions are as follows:
Does pecking order exist in the Kuala Lumpur Stock Exchange (klce)?
What are the implications of the presence or absences of pecking order in the KLCE on the firms?
1.9 Research Objectives
To identify the importance of pecking theory with relevance to corporate financial decisions in Malaysia .
To apply the pecking theory to the appropriate Bursa Malaysia public listed firms
To source data from Financial statements of the firms understudy, and design an appropriate methodology to analyse the data and determine if pecking order exists in the Kuala Lumpur Stock Exchange.
1.10 Justification of study
1.11 Research hypothesis
1.12 Assumptions
In this research, it is assumed that the sample of 90 firms from the Bursa Malaysia represent the entire Kuala Lumpur Stock Exchange.
1.13 Scope
This research focuses on 90 companies from the Bursa Malaysia main board, 10 from each of the 9 industries on the Bursa Malaysia. The period of study is from 2002 to 2008.
1.14 Outline of study
1.14.1 Chapter 1
This chapter deals with the background of research, research questions, justification of research, methodology, outline of thesis, definition of key terms, scope and assumptions, and conclusion.
1.14.2 Chapter 2
Chapter 2 deals with the literature review. It contains critical evaluation and discussion of other research related to pecking order.
1.14.3 Chapter 3
This chapter deals with methodologies used in this research. It shows the models to be used with the data sourced from the chosen firms
1.14.4 Chapter 4
This chapter deals with data analysis and discussion.
1.14.5 Chapter 5
This final chapter looks at implications, recommendations, suggestions for future research and conclusion
CHAPTER 2:LITETATURE REVIEW
2.1:Literature review
2.2 Pecking Order Theory
A Rational Justification of the Pecking Order Hypothesis to the Choice of Sources of Financing, Vuong Duc Hoang Quan, Asian Institute of Technology, Bangkok, Volume 25 Number 12 2002
Testing of Pecking Order Theory in ISE (Istanbul Stock Exchange Market), Mehmet ÅžEN and Eda ORUÇ Akdeniz University, International Research Journal of Finance and Economics - Issue 21 (2008)
Testing the pecking order theory: The importance of methodology, Dimitrios Vasiliou, et al. Qualitative Research in Financial Markets Vol. 1 No. 2, 2009 pp. 85-96
An examination of capital structure in the restaurant industry,
Arun Upneja and Michael C. Dalbor, International Journal of Contemporary hospitality Management 13, 2001
2.3 Leverage Level within the Concept of Pecking Order Theory and the Relation between Varied Financial Variables
2.4 Summary of literature review
No
Author
Year
Topic
Variables
Model/tests
Findings/remarks
1
Vuong Duc Hoang Quan
2002
2
Mehmet ÅžEN and Eda ORUÇ
2008
3
Dimitrios Vasiliou, et al.
2009
5
Arun Upneja and Michael C. Dalbor
2001
6
7
8
9
10
2.5 Market Efficiency
2.5.1 Weak-form efficient market hypothesis
2.5.2 Semi Strong-form efficient market hypothesis
2.5.3 Strong-form efficient market hypothesis
2.6 Kuala Lumpur Stock Exchange (klse) Background
2.7 Malaysia's Economic Background
2.8 Conclusion
CHAPTER 3: METHODOLOGY
3.1 Introduction
CHAPTER 4:FINDINGS AND ANALYSIS
4.1 Introduction
CHAPTER 5:SUMMARY AND CONCLUSION
5.1 Introduction
APPENDICES
REFERECES
Vuong Duc Hoang Quan (2002) A Rational Justification of the Pecking Order Hypothesis to the Choice of Sources of Financing, , Asian Institute of Technology, Bangkok, Volume 25 Number 12
Mehmet ÅžEN and Eda ORUÇ,(2008) Testing of Pecking Order Theory in ISE (Istanbul Stock Exchange Market), Akdeniz University, International Research Journal of Finance and Economics - Issue 21
Jensen, M., and Meckling, W. 1976. Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3: 305-360
