Valuation, 7th Edition

Appendix EOther Capital Structure Issues

This appendix discusses alternative models of capital structure and credit rating estimations. These models offer some interesting insights but tend to be less useful in practice for designing a company’s capital structure. Finally, the appendix shows the similarities and differences between widely used credit ratios such as leverage, coverage, and solvency.

Pecking-Order Theory

An alternative to the view that there are trade-offs between equity and debt is a school of thought in finance theory that sees a pecking order in financing.¹ According to this theory, companies meet their investment needs first by using internal funds (from retained earnings), then by issuing debt, and finally by issuing equity. One of the causes of this pecking order is that investors interpret financing decisions by managers as signals of a company’s financial prospects. For example, investors will interpret an equity issue as a signal that management believes shares are overvalued. Anticipating this interpretation, rational managers will turn to equity funding only as a last resort, because it could cause the share price to fall. An analogous argument holds for debt issues, although the overvaluation signal is much smaller because the value of debt is much less sensitive to a company’s financial success.²

According to the theory, companies will have lower leverage when they are more mature and profitable, simply because they can fund internally and do not ...