What is the Pecking Order Theory?

The Pecking Order Theory, also known as the Pecking Order Model, relates to a
company’s capital structure. Suggested by Donaldson in 1991, and later modified
and made popular by Stewart Myers and Nicolas Majluf in 1984, the theory states
that managers follow a hierarchy when considering sources of financing.

The pecking order theory states that managers are given a preference to fund
investment opportunities using three sources: first through the company’s
retained earnings, followed by debt, and choosing equity financing as a last
resort.

Understanding the Pecking Order Theory

The pecking order theory arises from the concept of asymmetric information.
Asymmetric information, also known as information failure, occurs when one
party possesses better information than the other party, which causes an
imbalance in transaction power.

Company managers typically possess more information regarding the company’s

performance, prospects, risks, and future outlook than external users such as
creditors (debt holders) and investors (shareholders). Therefore, to compensate
for information asymmetry, external users demand a higher return to counter the
risk that they are taking. In essence, due to information asymmetry, external
sources of finances demand a higher rate of return to compensate for risk.

In the context of the pecking order theory, retained earnings financing (internal
financing) comes directly from the company and minimizes information
asymmetry. As opposed to external financing such as debt and equity financing
where the company must incur fees to issue external financing, internal financing
is the cheapest and most convenient source of financing.

On the other hand, when a company finances an investment opportunity through

external financing (debt and equity), a higher return is demanded because
creditors and investors possess less information regarding the company as
opposed to managers. In terms of external financing, managers prefer to raise
debt over equity – the cost of debt is lower compared to the cost of equity.

The issuance of debt signals an undervalued stock and confidence that the board
believes the investment is profitable. On the other hand, the issuance of equity
sends a negative signal that the stock is overvalued and that the management is
looking to generate financing by diluting shares in the company.

When thinking of the pecking order theory, it is useful to consider the seniority of
claims to assets. Debtholders require a lower return as opposed to stockholders
because they are entitled to a higher claim to assets (in the event of a
bankruptcy). Therefore, when considering sources of financing, the cheapest is
through retained earnings, second through debt, and third through equity.
Example of the Pecking Order Theory

Suppose ABC Company is looking to raise $10 million for an investment project.
The company’s stock price is currently trading at $53.77. Three options are
available for ABC Company:

1. Finance the project directly through retained earnings;

2. One-year debt financing with an interest rate of 9%, although management
believes that 7% is the fair rate; or
3. Issuance of equity that will underprice the current stock price by 7%.

What would be the cost to shareholders in each of the three options?

Option 1: If management finances the project directly through retained earnings,

the cost is $10 million.

Option 2: If management finances the project through debt issuance, the one-
year debt would cost management $10.8 million ($10 x 1.08 = $10.8). Discounting
it back one year with the management’s fair rate would yield a cost of $10.09
million ($10.8 / 1.07 = $10.09 million).

Option 3: If management finances the project through equity issuance, to raise

$10 million, the company would need to sell 200,000 shares ($53.77 x 0.93 = $50,
$10,000,000 / $50 = 200,000 shares). The true value of the shares would be
$10.75 million ($53.77 x 200,000 shares = $10.75 million). Therefore, the cost
would be $10.75 million.

As illustrated, management should first finance the project through retained

earnings, second through debt, and lastly through equity.

Key Takeaways of the Pecking Order Theory

The pecking order theory relates to a company’s capital structure in that it helps
explain why companies prefer to finance investment projects with internal
financing first, debt second, and equity last. The pecking order theory arises from
information asymmetry and explains that equity financing is the costliest and
should be used as a last resort to obtain financing.