Pecking Order Theory
The pecking order theory is a theory of corporate financing that holds that firms prefer internal funds to external funds and, when external funds are needed, prefer debt to equity. The theory, developed by Stewart Myers and others, explains observed financing patterns as a consequence of information asymmetries between managers and investors.
Information Asymmetry
The theory rests on the idea that managers know more about the firm's prospects than outside investors. When a firm issues equity, investors may interpret the issue as a signal that managers believe the shares are overvalued, and the share price may fall. Debt issuance is less subject to this problem, because debt has a fixed claim and its value is less sensitive to private information, at least for firms with low default risk.
Internal funds, such as retained earnings, avoid the information problem entirely, since they are not subject to the scrutiny that accompanies external issuance. Firms therefore prefer to finance investment from internal funds, and they turn to external finance only when internal funds are insufficient.
Financing Hierarchy
The pecking order implies a hierarchy of financing sources: internal funds first, then debt, and equity last. Firms issue equity only as a last resort, when they have exhausted internal funds and have limited capacity for additional debt.
The theory contrasts with the trade-off theory, which holds that firms choose their capital structure by balancing the tax benefits of debt against the costs of financial distress. In the trade-off theory, firms have a target leverage ratio and adjust toward it; in the pecking order, financing choices reflect the availability of internal funds and the costs of external finance, and there is no target ratio.
Empirical Evidence
Empirical evidence provides support for both theories, and neither explains all observed behaviour. Consistent with the pecking order, firms with high profitability tend to have lower leverage, since they have more internal funds and less need for external finance, a pattern opposite to the prediction of the trade-off theory, in which profitable firms should borrow more to shield income from tax.
Consistent with the trade-off theory, firms in industries with stable cash flows tend to have higher leverage, and firms adjust toward leverage targets. The evidence suggests that financing behaviour reflects a combination of factors, including information asymmetry, taxes, and the costs of distress.
Implications
The pecking order has implications for corporate investment, capital structure, and the response of firms to shocks. Firms with ample internal funds can invest without raising external finance, while firms facing financing constraints may pass up profitable investments.
The theory also informs the analysis of the market reaction to security issuance, since the choice of instrument conveys information to investors. It contributes to the broader understanding of how information and incentives shape corporate financial decisions, and it complements the analysis of agency problems and contracting.
Debt Capacity and Financial Slack
The pecking order implies that firms value financial slack, the reserve of cash and unused debt capacity that allows them to undertake investment without resorting to external equity. Firms with ample slack can seize opportunities without the adverse price reaction that accompanies equity issuance.
The accumulation of slack reflects the trade-off between the cost of holding liquid assets, which earn low returns, and the benefit of financial flexibility. The pecking order predicts that firms with greater investment opportunities and higher information asymmetry will hold more slack, since the cost of external finance is higher for them.
Debt Overhang and Underinvestment
The pecking order is related to the problems of debt overhang and underinvestment. When a firm has substantial debt, the benefits of new investment may accrue to creditors, reducing the incentive of shareholders to fund it. The resulting underinvestment is a cost of high leverage, and it interacts with the financing hierarchy.
Where a firm faces debt overhang, the issuance of new equity may dilute existing shareholders while benefiting creditors, making equity issuance unattractive. The firm may therefore forego investment even when the pecking order would otherwise favour it, a further distortion arising from financial structure.
Market Timing and Behavioural Factors
An alternative explanation for financing patterns emphasises market timing, the practice of issuing equity when managers believe shares are overvalued and repurchasing when they believe they are undervalued. Managers' perceptions of valuation, rather than information asymmetry alone, drive the choice of instrument.
The market timing explanation overlaps with the pecking order, since both predict that equity issuance follows periods of high valuations and that firms avoid equity when they believe shares are cheap. The relative importance of the two explanations is debated, and the evidence suggests that both play a role.
Implications for Corporate Governance
The pecking order has implications for corporate governance and for the design of contracts. Because financing choices convey information, the structure of claims affects the incentives of managers and the monitoring by investors. Debt disciplines managers by committing them to fixed payments, while equity gives them discretion but exposes them to the discipline of the market.
The design of governance arrangements must balance these considerations. The pecking order contributes to the understanding of how firms choose among instruments and how those choices affect their subsequent behaviour and performance. The theory remains a central element of corporate finance, complementing the trade-off theory and the analysis of agency problems.