Pecking order theory is a theory related to capital structure. Donaldson initially suggested it. In 1984, Myers and Majluf modified the theory and made it famous. According to this theory, managers follow a hierarchy to choose sources of finance. The hierarchy gives first preference to internal financing. If internal financing is not enough, then managers would have to shift to external sources. They will issue debt to generate funds. After a point when it is no longer practical to issue more debt, equity is issued as a last option.
Internal Financing vs. External Financing
The pecking order theory begins from the asymmetry of information in the organization. Asymmetric information is an unequal distribution of information. The managers generally have more information about the company’s performance, prospects, and risks than outside creditors or investors. Some companies have a high level of asymmetric information like companies with complex or technical products, companies with less accounting transparency, etc. Higher the asymmetry of information, the higher the risk for the company.
Also, it is not possible for investors to know everything about a company. So, there will always be some amount of information asymmetry in every company. If a creditor or an investor has less information about the company, they will demand higher returns against the risk taken. Along with providing higher returns, the company will have to incur costs to issue the debt and equity. To ensure shareholders ‘ interests are maximized, it will also have to incur some agency costs like paying the board of directors’ fees. All these reasons make retained earnings a cheaper and more convenient source of finance than external sources.
Debt Financing vs. Equity Financing
If a company does not have sufficient retained earnings, then it will have to raise money through external sources. Managers would prefer debt over equity because the cost of debt is lower than the cost of equity. The company issuing new debt will increase the proportion of debt in the capital structure, providing a tax shield. So this will reduce the weighted average cost of capital (WACC).
After a certain point, increasing the leverage in the capital structure will be very risky for the company. The company will have to issue new equity shares as a last resort in such scenarios.
Signals from the Choice of Finance
A company’s choice of finance sends some signals in the market. If a company is able to finance itself internally, it is considered to be a strong signal. It shows that the company has enough reserves to take care of funding needs. If a company issues debt, it shows that management is confident to meet the fixed payments. If a company finances itself with new stock, it’s a negative signal. The company generally issues new stock when it perceives the stock to be overvalued.
All the above-mentioned logic is applied to develop the hierarchy of pecking order theory. This hierarchy should be followed while making decisions related to capital structure.