Why Should You Avoid Buying Shares in Capital-Intensive Companies? Pecking Order Theory…
If the financial leverage optimization theory (Trade-off Theory) works in practice, then why don’t managers strive towards targeted leverage? Why do leverage levels differ among corporations in the same industry?
The Pecking Order Theory explains managers’ behavior as follows:
The theory relies on information asymmetry between managers and shareholders. Managers have more information, and their actions are read indirectly by shareholders.
If a manager is optimistic and believes that the stock price of their company is lower than its intrinsic value, they will take on debt and not issue new shares. If the manager is pessimistic, logically, they should issue shares, but doing so would negatively impact the stock price. Therefore, they also take on debt as long as they can (creating a bubble).
Thus, managers predominantly try to finance investments with internal resources (profits) and, if that is insufficient, they take on debt in all cases. Hence, issuing additional equity only happens when the business is under stress.
This theory concludes that having a financial cushion (cash) is essential to fund interesting opportunities. If this cushion is absent, the company will quickly resort to stressful debt and eventually raise money with devalued capital…
However, a financial cushion has its problems – managers tend to spend excess cash non-productively.
Research findings on what affects the D/(D+E) ratio:
- Corporation Size – Large companies have large debts;
- Tangible Assets – Large fixed assets stimulate more debt;
- Profitability – High profitability leads to low debt;
- Market-to-Book – The higher this ratio, the lower the debt proportion in financing.
P.S.
It appears that smart investors highly trust this theory because they look for high-margin and low capital-intensive companies. The likelihood of distress for such companies is much lower. However, margin alone is not enough to see if an organization has a competitive advantage. Accounting margins may be driven by owning large production assets and real estate (alternative costs do not appear in financial statements).
Such capital-intensive organizations grow slowly because growth requires reinvesting a large portion of profits. Imagine how difficult it would be for such an organization to double its sales…
Principles of Corporate Finance – by F. Allen, R. A. Brealey, & S. Myers