Pecking Order Theory for Sources of Finance to Raise Finance (part 1)

Pecking order theory ranks sources of finance in the order of cost of finance. Following sources of finance are arranged in increasing order of cost of finance.

Pecking order theory facilitates selection of financing methods according to cost of finance, risk, control, accessibility, tax benefits. In addition to pecking order theory, legal status of business such as sole proprietorship, partnership, private and public limited company) and attitude of business owner/managers.

Retained Earnings

Retained earnings are internally generated earnings, which are saved after payment of dividend to shareholders or earnings left after making consumer expenditure.

Cost of finance

Retained earnings are cheapest source of finance it requires no interest payment. Maximum cost of using retained earning as a source of finance will be opportunity cost of not being able to use retained earnings as a source of finance.

Risk

Retained earnings are less risky than all other sources of finance as retained earnings do not lead to legal liabilities for external reporting and payment of interest.

Retained earnings is suitable for pursuing incremental growth. Incremental growth is a low risk strategy. It allows business owner/managers to invest gradually rather than making one large investment.

Control

Use of retained earning as a source of finance prevents business owner/managers from outside interference. Even, if debt finance (see below) is used as a source of finance, then it may lead to restricted covenants, which may limit business owner/manger ability to take investment and financial decisions.

Tax benefit

Retained earning does not involve cash outflow. However, it has opportunity cost of loss of internet income. Tax rules in most jurisdiction allows only those expenses involving cash outflow. Non-cash expenses such as opportunity cost, bad debts expense, impairment of assets are not allowed for tax purpose.

Convertible Loan Notes

Convertible loan notes is a type of debt finance with a conversion option (right but not an obligation)to buy certain number of equity shares at pre-specified exercise price at maturity.

Cost of finance

Convertible loan notes are less expensive than debt finance (see below). Reduction in interest payment (expense) is take account of conversion option. Investor may agree on lower interest payments for future gains.

Risk

Use of convertible loan notes is considered less risky for business owner/manager. If conversion option is in the money, then presumably investors would exercise conversion option. However, convertible loan notes are also redeemable at maturity just as debt finance. Investor may prefer to redeem convertible loan notes rather than exercise an option (right but not an obligation) to buy equity shares.

Control

Convertible loan notes can result in transfer/dilution of control, if significant number of investors exercise conversion option. New shareholders may not have same preference for dividends, investments and risk.

Access

Convertible loan notes can only be used by publicly listed companies. Loan notes (either convertible or not) are an negotiable instrument traded in stock market/exchange.

Share is term used for equity finance in UK and stock is term used for equity finance in US.

Tax benefit

Convertible loan notes results in cash outflow in the form of interest payments. Interest payments (expense) are tax deductible expense in most jurisdictions. It reduces the cost of finance even lower by the percentage of tax rate applicable to business.

Tax benefit will cease on either redemption or conversion of loan notes into equity shares.

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Pecking Order Theory for Sources of Finance to Raise Finance (Part 2)

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Debt Finance

Debt finance is a source of finance, which is borrowed with an legal obligation to repay at maturity date. Debt finance usually bears an obligation to pay interest. However, debt finance can also be issued at zero interest rate.

Cost of finance

Debt finance is cheaper source of finance than convertible loan notes. However, it is more expensive than preference share capital and equity finance. Debt finance holders have legal protection and can enforce payments in the event of default. Therefore, they agree at lower returns for low risk.

Risk

Debt finance is less risky for investors. However, it is more risky for business owner/managers. Non payment of interest or principle amount can force the business into liquidation/dissolution by the creditors (Debt finance holders).

Control

Debt finance does not result in transfer/dilution of control. Debt finance holders have no voting rights. Therefore, debt finance holders cannot influence strategic, investment and financial decisions.

Access

Debt finance is accessible to both listed and unlisted businesses (private limited companies, partnerships and sole proprietors).

Debt finance is available in variety of forms such as bank loan (secured and unsecured), loan notes (also known as debentures and bonds), convertible loan notes, zero coupon bonds, deep discount bonds, redeemable preference shares etc.

Tax benefits

Interest paid to debt finance holders is tax deductible expense for tax purpose. It reduces the cost of finance even lower by the percentage of tax rate applicable to business.

Irredeemable Preference Share Capital

Preference share capital have prior rights in respect of dividend and claim on surplus assets in the event of winding up. Preference shareholders (redeemable or irredeemable) are the owner of the company according to company law. However, only irredeemable preference shareholders are considered as the owner for financial decision making.

Cost of finance

Irredeemable preference share capital is more expensive than debt finance (including redeemable preferences share capital). However, it cheaper than equity finance. Irredeemable preference shareholders may agree at lower returns for prior right in dividends and claim on surplus assets.

Risk

Preference shareholders are owner of the company. They are not required to pay until liquidation of the company. They cannot enforce dividend payments. However, if dividend is declared then they have receive dividend earlier than equity finance holders.

Control

Preference shareholders have no voting rights unless decision under consideration involves changes in rights of preference shareholders with respect to par value, percentage of dividend payable etc. Therefore, preference shareholders cannot influence the strategic, investment, financial decisions taken by managers. It means preference shareholders cannot appoint and remove managers in AGM.

Access

Preference holder capital (redeemable and irredeemable) can only be issued by publicly listed companies.

Tax benefit

Preference shareholders are owners of the company according to company law and paid dividends. Dividends are not tax deductible expense.

Equity Finance

Equity finance holders have residual claim on dividends and surplus assets of the company in the event of liquidation. They are considered owners from both legal and financial viewpoint.

Cost of finance

Equity finance is most expensive source of finance. Return required by equity finance holders depends on perception of risk (financial and business risk) profile of the company. Equity finance holders usually require higher return than debt finance holders to compensate themselves for additional risk (financial and business risk) faced by equity holders due to investment in the company.

Level of return required by equity shareholders is reflected in the market share price of publicly listed companies.

Private limited companies can also have market share price, if listed on AIM (Alternative Investment Market)

Risk

Equity finance more risky for equity finance holders. However, equity finance is less risky for business owners. Equity finance is not legally required to pay dividends and repay principle amount invested until winding up.Therefore, it does not bears the risk of forced liquidation as risk associated with debt finance.

Control

Equity finance result in transfer/dilution of control to the extent of equity finance raised. However, if equity finance is raised through right issue and it is 100% subscribed then it will result in transfer of control.

Access

Equity finance can be issued by both private and publicly listed companies.

Tax benefit

Equity shareholders are owners of the company according to company law. Equity shareholders are paid dividend rather than interest as compensation. Dividend payments are not tax deductible.