Pecking Order Theory
Encyclopedia
In the theory of firm's capital structure
and financing decisions, the Pecking Order Theory or Pecking Order Model was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers
and Nicolas Majluf in 1984 . It states that companies prioritize
their sources of financing (from internal financing
to equity
) according to the Principle of least effort
, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt
is issued, and when it is not sensible to issue any more debt, equity is issued.
Pecking Order Theory starts with asymmetric information as managers know more about their companies prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. There therefore exists a pecking order for the financing of new projects.
Asymmetric information favours the issue of debt over equity as the issue of debt signals the boards confidence that an investment is profitable and that the current stock price is under-valued (were stock price over-valued, the issue of equity would be favoured). The issue of equity would signal a lack of confidence in the board and that they feel the share price is over-valued. An issue of equity would therefore lead to a drop in share price. This does not however apply to high-tech industries where the issue of equity is preferable due to the high cost of debt issue as assets are intangible
. However, several author
s have found that there are instances where it is a good approximation
of reality. On the one hand, Fama and French, and also Myers and Shyam-Sunder find that some features of the data are better explained by the Pecking Order than by the Trade-Off Theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry
is presumably an important problem.
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
and financing decisions, the Pecking Order Theory or Pecking Order Model was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers
Stewart Myers
Stewart Clay Myers is the Robert C. Merton Professor of Financial Economics at the MIT Sloan School of Management. He is notable for his work on capital structure and innovations in capital budgeting and valuation, and has had a "remarkable influence" on both the theory and practice of corporate...
and Nicolas Majluf in 1984 . It states that companies prioritize
Priority
Priority may refer to:* Priority date, a concept of establishing waiting times in the immigration process by United States Department of State* Priority level, the priority of emergency communications...
their sources of financing (from internal financing
Internal financing
In the theory of capital structure, internal financing is the name for a firm using its profits as a source of capital for new investment, rather than a) distributing them to firm's owners or other investors and b) obtaining capital elsewhere. It is to be contrasted with external financing which...
to equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
) according to the Principle of least effort
Principle of least effort
The principle of least effort is a broad theory that covers diverse fields from evolutionary biology to webpage design. It postulates that animals, people, even well designed machines will naturally choose the path of least resistance or "effort". It is closely related to many other similar...
, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
is issued, and when it is not sensible to issue any more debt, equity is issued.
Pecking Order Theory starts with asymmetric information as managers know more about their companies prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. There therefore exists a pecking order for the financing of new projects.
Asymmetric information favours the issue of debt over equity as the issue of debt signals the boards confidence that an investment is profitable and that the current stock price is under-valued (were stock price over-valued, the issue of equity would be favoured). The issue of equity would signal a lack of confidence in the board and that they feel the share price is over-valued. An issue of equity would therefore lead to a drop in share price. This does not however apply to high-tech industries where the issue of equity is preferable due to the high cost of debt issue as assets are intangible
Evidence
Tests of the Pecking Order Theory have not been able to show that it is of first-order importance in determining a firm's capital structureCapital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
. However, several author
Author
An author is broadly defined as "the person who originates or gives existence to anything" and that authorship determines responsibility for what is created. Narrowly defined, an author is the originator of any written work.-Legal significance:...
s have found that there are instances where it is a good approximation
Approximation
An approximation is a representation of something that is not exact, but still close enough to be useful. Although approximation is most often applied to numbers, it is also frequently applied to such things as mathematical functions, shapes, and physical laws.Approximations may be used because...
of reality. On the one hand, Fama and French, and also Myers and Shyam-Sunder find that some features of the data are better explained by the Pecking Order than by the Trade-Off Theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
is presumably an important problem.
Profitability and debt ratios
The Pecking Order Theory explains the inverse relationship between profitability and debt ratios:- Firms prefer internal financing.
- They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends.
- Sticky dividend policies, plus unpredictable fluctuations in profits and investment opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the firm pays off the debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities, rather than reduce dividends.
- If external financing is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In addition, issue costs are least for internal funds, low for debt and highest for equity. There is also the negative signaling to the stock market associated with issuing equity, positive signaling associated with debt.
See also
- Capital structureCapital structureIn finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
- Capital structure substitution theoryCapital structure substitution theoryIn finance, the capital structure substitution theory describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share are maximized...
- Corporate financeCorporate financeCorporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
- Cost of capitalCost of capitalThe cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
- Market timing hypothesisMarket timing hypothesisThe market timing hypothesis is a theory of how firms and corporations in the economy decide whether to finance their investment with equity or with debt instruments. It is one of many such corporate finance theories, and is often contrasted with the pecking order theory and the trade-off theory,...
- Trade-Off Theory