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Pecking order theory is a theory related to capital structure. It was initially suggested by Donaldson. In 1984, Myers and Majluf modified the theory and made it popular.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 company’s performance, prospects and risks than outside creditors or investors. Some companies have a high level of asymmetric information like companies with a complex or technical product, companies with less accounting transparency etc. Higher the asymmetry of information, higher the risk in the company.
Also, it is not possible for the 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, he/she 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. It will also have to incur some agency cost like paying the board of directors’ fees to ensure shareholders’ interests are maximized. All these reasons make retained earnings a cheaper and 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 compared to the cost of equity. The company issuing new debt will increase the proportion of debt in the capital structure and it will provide a tax shield. So this will reduce the weighted average cost of capital (WACC).
After a certain point, increasing the leverage in capital structure will be very risky for the company. In such scenarios, the company will have to issue new equity shares as a last resort.
SIGNALS FROM THE CHOICE OF FINANCE
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 company has enough reserves to take care of funding needs. If a company issues a 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 logics are applied to develop the hierarchy of pecking order theory. This hierarchy should be followed while taking decisions related to capital structure.
CFA Level 1 Curriculum, 2016