In corporate finance, the pecking order theory (or pecking order model) postulates that the cost of financing increases with asymmetric information. Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a “last resort”.
Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant ‘bringing external ownership’ into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance.
The pecking order theory is popularized by Myers and Majluf (1984) where they argue that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation.
As a result, investors will place a lower value to the new equity issuance. 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.
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.
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.