Proceedings

The “free cash flow” term is the amount by which a company’s operating cash flow
exceeds what can be profitably reinvested in its basic business and the emphasis is
here on the word profitably. Conflicts of interest between stockholders and managers
over payout policies are especially severe when the organization generates substantial
free cash flow (Frydenberg, 2008).
Profitability affects leverage in at least two directions. First, higher profitability
usually provides more internal financing. More earnings can be kept in the company
and hence a lower level of debt. Less debt is then needed to finance already planned
investments. Secondly, debt introduces an agency cost argument. Management will
refrain from the building of empires and excessive consumption of perquisites, when
large sums of money must be paid to creditors each year. Debt keeps the company
slim and cost efficient. Unnecessary non-profitable investments will be avoided
because creditors demand annual payments and claim any free cash flow. High
profitability should result in higher leverage according to the free cash flow
hypothesis, but a high leverage would result in high profitability on the basis of the
pecking order hypothesis.
1.2. The pecking order theory
Issuing debt minimizes the managers' information advantage. Optimistic managers,
who believe their companies' shares are undervalued, will jump at the chance to issue
debt rather than equity. Only pessimistic managers will want to issue equity. If debt is
an open alternative, then any attempt to sell shares will reveal that the shares are not a
good buy. Therefore investors will spurn equity issues if debt is available on fair
terms, and in equilibrium only debt will be issued. Equity issues will occur only when
debt is costly, for example because the company is already at a dangerously high debt
ratio where managers and investors foresee costs of financial distress. In this case
even optimistic managers may turn to the stock market for financing.
This leads us to the pecking-order theory of capital structure (Myers, 2003).
Companies prefer internal to external finance (Information asymmetries are assumed
relevant only for external financing). Dividends are "sticky", so that dividend cuts are
not used to finance capital expenditure, and changes in cash requirements are not
soaked up in short-run dividend changes. Changes in free cash flow (operating cash
flow less investment) show up as changes in external financing.
If external funds are required for capital investment, companies will issue the safest
security first, that is, debt before equity. As the requirement for external financing
increases, the company will work down the pecking order, from safe to riskier debt
and finally to equity as a last resort, when the company is sufficiently threatened by
financial distress. If internally generated cash flow exceeds capital investment, the
company works up the pecking order. Excess cash is used to pay down debt rather
than repurchasing and retiring equity. The company's debt ratio therefore reflects its
cumulative requirement for external financing.
According to the pecking order theory, the companies will prefer internal financing.
The companies prefers internal to external financing, and debt to equity if the
company issues securities. In the pure pecking order theory, the companies have no
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