Introductory Corporate Finance: Leverage - Pecking Order Theory, Internal Financing Debt Equity Order of Preference

What This Is

The Pecking Order Theory (POT) explains how firms prefer to finance their investments using internal funds, debt, and equity in a specific order. This theory matters in corporate finance as it helps firms make informed capital structure decisions, minimizing costs and maximizing shareholder value. For example, consider Tesla, which has consistently generated significant free cash flow (FCF) from its operations, allowing it to finance its investments in electric vehicle production and expansion without relying heavily on debt or equity issuances.

Key Formulas & Models

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
• wd: proportion of debt in capital structure
• rd: cost of debt (1 - T)
• T: corporate tax rate
• wps: proportion of preferred stock in capital structure
• rps: cost of preferred stock
• we: proportion of equity in capital structure
• re: cost of equity
• FCF = EBIT(1 - T) + Depreciation - Capital Expenditures - Change in Working Capital – free cash flow; measures a firm's ability to generate cash from operations.
• DFL = EBIT(1 - T) - Interest – debt-free leverage; measures a firm's ability to generate cash from operations without considering interest expenses.
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – sustainable growth rate; measures a firm's long-term growth potential.
• ROE = Net Income / Total Equity – return on equity; measures a firm's profitability.
• Retention Ratio = 1 - Dividend Payout Ratio – retention ratio; measures a firm's ability to retain earnings.
• Dividend Payout Ratio = Dividends / Net Income – dividend payout ratio; measures a firm's ability to distribute earnings to shareholders.
• Debt Capacity = EBIT(1 - T) / (r - g) – debt capacity; measures a firm's ability to take on debt without increasing its cost of capital.

Step-by-Step Calculation

1. Calculate free cash flow (FCF) using the formula: FCF = EBIT(1 - T) + Depreciation - Capital Expenditures - Change in Working Capital.
2. Calculate debt-free leverage (DFL) using the formula: DFL = EBIT(1 - T) - Interest.
3. Calculate return on equity (ROE) using the formula: ROE = Net Income / Total Equity.
4. Calculate retention ratio using the formula: Retention Ratio = 1 - Dividend Payout Ratio.
5. Calculate sustainable growth rate using the formula: Sustainable Growth Rate = ROE × (1 - Retention Ratio).

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value for WACC, as it reflects the current market price of a firm's securities.
• Counterexample: If a firm has a market value of $100 million and a book value of $50 million, using book value would result in an incorrect WACC calculation.
• Mistake: Ignoring flotation costs when calculating WACC.
• Correction: Include flotation costs in the WACC calculation to accurately reflect the cost of issuing new securities.
• Counterexample: If a firm issues $10 million in new debt at a flotation cost of 2%, the correct WACC calculation would include this cost.
• Mistake: Confusing sunk cost with opportunity cost.
• Correction: Distinguish between sunk costs (irrecoverable costs) and opportunity costs (foregone benefits).
• Counterexample: If a firm invests $10 million in a project that generates $15 million in revenue, the opportunity cost is $5 million, not the $10 million investment.

Exam / CFA Tips

• Tip: Be able to distinguish between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
• Tip: Understand the difference between IRR and NPV ranking.
• Tip: Be able to explain the concept of dividend irrelevance and bird-in-hand.

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and a tax rate of 25%. Calculate debt-free leverage (DFL).

Answer: DFL = $10 million (1 - 0.25) - $2 million = $7.5 million

Explanation: This calculation assumes that the company has no capital expenditures or change in working capital.

Last-Minute Cram Sheet

1. WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital.
2. In M&M Proposition I (no taxes), firm value is independent of capital structure.
3. FCF = EBIT(1 - T) + Depreciation - Capital Expenditures - Change in Working Capital – free cash flow.
4. DFL = EBIT(1 - T) - Interest – debt-free leverage.
5. Sustainable Growth Rate = ROE × (1 - Retention Ratio) – sustainable growth rate.
6. ROE = Net Income / Total Equity – return on equity.
7. Retention Ratio = 1 - Dividend Payout Ratio – retention ratio.
8. Debt Capacity = EBIT(1 - T) / (r - g) – debt capacity.
9. Ignoring flotation costs can lead to incorrect WACC calculations.
10. Sunk costs are irrecoverable costs, while opportunity costs are foregone benefits.