What Does Pecking Order Theory Say?

The Pecking Order Theory offers a perspective on how companies make decisions about their financial structure. It suggests a hierarchy in the way businesses prefer to fund their operations and growth initiatives. Developed by finance researchers Stewart Myers and Nicholas Majluf, this theory attempts to explain the observed patterns in corporate financing choices. It provides a framework for understanding why some sources of capital are favored over others.

Defining Pecking Order Theory

The Pecking Order Theory posits that companies prioritize their financing sources based on their accessibility and the costs associated with them. At its core, the theory states that firms prefer to use internal funds first, then debt, and as a last resort, new equity issuance. This preference hierarchy is largely driven by information asymmetry, where company management possesses more detailed and accurate information about the firm’s true value and future prospects than external investors.

Information asymmetry creates a situation where external investors may misinterpret a company’s financing decisions. For instance, if a company issues new stock, investors might assume management believes the stock is overvalued, leading to a potential decrease in share price. Conversely, if a company relies on internal funds, it signals financial strength and confidence in its current operations. This imbalance of information influences how companies approach their capital structure.

The Preferred Order of Financing

According to the Pecking Order Theory, the most preferred method of financing for a company is through internally generated funds, primarily retained earnings. These funds are readily available and do not incur flotation costs, such as underwriting fees or legal expenses, which are common with external financing. Using retained earnings also avoids the signaling costs associated with external capital, as it does not convey any specific message to the market about the company’s valuation or future prospects.

When internal funds are insufficient, companies typically turn to debt financing as their second preference. Debt is generally favored over equity for external financing because it is less susceptible to the negative signaling effects of information asymmetry. Lenders are primarily concerned with a company’s ability to repay the loan, which is often less complex to assess than the future growth prospects relevant to equity investors. Additionally, the transaction costs associated with issuing debt are often lower than those for equity.

Issuing new equity, or common stock, is considered the least preferred option for financing under this theory. This reluctance stems from significant signaling costs, as the market may interpret a new stock issuance as a sign that management believes the company’s shares are currently overvalued. Such an interpretation can lead to a drop in the stock price. Furthermore, external equity issuance involves substantial transaction costs, including investment banking fees, legal expenses, and regulatory compliance costs.

Why Companies Follow This Order

Companies adhere to the pecking order primarily due to information asymmetry between management and outside investors. Management aims to avoid actions that could be misinterpreted by the market, such as issuing new equity when the stock is undervalued. This would dilute existing shareholders and signal weakness, as external investors often perceive new equity issuance negatively.

Minimizing various costs also plays a significant role. Different financing methods incur varying transaction costs, from virtually no direct costs for retained earnings to substantial fees for issuing new equity. Prioritizing internal funds and debt helps companies preserve capital.

Signaling costs, related to market perception, further reinforce this preference. Issuing debt generally sends a more neutral or positive signal. Conversely, announcing a new stock issuance often carries a negative signal, potentially leading to a decline in share price. Managerial preferences also contribute, as management may prefer to avoid increased scrutiny and potential loss of control or earnings dilution.

Real-World Applications

In practice, the principles of the Pecking Order Theory are frequently observed in corporate financing decisions. Profitable companies often rely on retained earnings to fund new investments, research and development, or acquisitions. This approach allows them to avoid the complexities and costs of external capital markets. For example, a company might use its profits to upgrade manufacturing facilities rather than seeking a bank loan or issuing new stock.

When internal funds are insufficient, companies commonly turn to debt, such as bank loans, lines of credit, or corporate bonds, to finance larger projects or initiatives. A company looking to expand into a new market might secure a term loan, finding it a more straightforward and less dilutive option than issuing shares. This aligns with the theory that debt is the next preferred source after internal funds, due to its lower signaling and transaction costs compared to equity.

Issuing new equity is typically reserved for situations where a company has exhausted its internal funds and debt capacity, or when it needs a significant infusion of capital for transformative growth. A rapidly expanding technology firm might issue new stock to fund a large-scale international expansion that requires capital beyond what debt markets can reasonably provide. While the theory simplifies complex financial decisions, its core tenets often provide a useful lens for understanding corporate financing behaviors in the United States.