Intro to Finance: Capital Structure - Pecking Order Theory, Internal Funds Debt Equity

What This Is

The Pecking Order Theory (POT) is a financing framework that explains how firms prioritize their capital structure decisions. It suggests that firms prefer to use internal funds (retained earnings) before issuing debt and equity. This theory matters in finance because it helps investors and analysts understand a company's financing choices and their implications on the firm's value. For example, Apple Inc. has consistently generated significant internal funds through its profitable operations, allowing it to invest in new products and services without relying heavily on debt or equity issuances.

Key Formulas & Symbols

• Internal Funds (IF) = Net Income + Depreciation + Change in Working Capital where IF = internal funds, Net Income = net income, Depreciation = depreciation expense, Change in Working Capital = change in current assets and liabilities.
• Debt Capacity (DC) = EBITDA / (r * (1 - t)) where DC = debt capacity, EBITDA = earnings before interest, taxes, depreciation, and amortization, r = cost of debt, t = tax rate.
• Cost of Debt (r_d) = (Interest Expense / Debt) + (1 - t) * (r_f) where r_d = cost of debt, Interest Expense = interest expense, Debt = debt, r_f = risk-free rate, t = tax rate.
• Cost of Equity (r_e) = r_f +-* (E(R_m) - r_f) where r_e = cost of equity, r_f = risk-free rate,-= beta, E(R_m) = expected market return.
• Weighted Average Cost of Capital (WACC) = (D / (D + E)) * r_d + (E / (D + E)) * r_e where WACC = weighted average cost of capital, D = debt, E = equity, r_d = cost of debt, r_e = cost of equity.
• Debt-to-Equity Ratio (D/E) = Total Debt / Total Equity where D/E = debt-to-equity ratio, Total Debt = total debt, Total Equity = total equity.

Step-by-Step Calculation

1. Calculate internal funds (IF) using the formula: IF = Net Income + Depreciation + Change in Working Capital.
2. Estimate debt capacity (DC) using the formula: DC = EBITDA / (r * (1 - t)).
3. Calculate the cost of debt (r_d) using the formula: r_d = (Interest Expense / Debt) + (1 - t) * (r_f).
4. Estimate the cost of equity (r_e) using the formula: r_e = r_f +-* (E(R_m) - r_f).
5. Calculate the weighted average cost of capital (WACC) using the formula: WACC = (D / (D + E)) * r_d + (E / (D + E)) * r_e.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value for WACC because it reflects the current market price of debt and equity.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR (Internal Rate of Return) is the discount rate that makes NPV equal to zero, while NPV (Net Present Value) is the difference between the present value of cash inflows and outflows.
• Mistake: Ignoring the tax shield effect on debt.
• Correction: The tax shield effect reduces the cost of debt and increases the debt capacity.

Exam / CFA Tips

• Tip: Be careful with the order of operations when calculating WACC.
• Tip: Use the correct formula for cost of debt, including the tax shield effect.
• Tip: Be prepared to estimate debt capacity using the EBITDA formula.

Quick Practice Problem

Apple Inc. has a net income of $50 billion, depreciation expense of $10 billion, and a change in working capital of $5 billion. What is Apple's internal funds (IF)?

Answer: IF = $50 billion + $10 billion + $5 billion = $65 billion.

Last-Minute Cram Sheet

• The Pecking Order Theory prioritizes internal funds over debt and equity.
• The cost of debt (r_d) includes the tax shield effect.
• WACC = (D / (D + E)) * r_d + (E / (D + E)) * r_e.
• Debt capacity (DC) = EBITDA / (r * (1 - t)).
• Internal funds (IF) = Net Income + Depreciation + Change in Working Capital.
• The dividend discount model (DDM) requires g < r – otherwise the model explodes.
• Cost of equity (r_e) = r_f +-* (E(R_m) - r_f).
• Debt-to-equity ratio (D/E) = Total Debt / Total Equity.