Pecking Order Theory
The pecking order theory of the capital structure is a theory in corporate finance. The theory tries to explain why companies prefer to use one type of financing over another. The main reason is that the cost of financing tends to increase when the degree of asymmetric information increases. The pecking order theory is one of the most well-known capital structure theories. The provides an explanation of capital structure companies is dominated by debt. The theory was first proposed by Myers and Majluf in 1984.
On this page, we explain the pecking order theory of the capital structure definition, explain the importance of asymmetric information, and discuss a pecking order theory example.
Pecking order definition
The Pecking Order Theory or Pecking Order Model states that the cost of financing increases as companies use sources of funding where the degree of asymmetric information is higher. As companies raise more and more capital, it becomes increasingly hard to obtain such funding internally. Instead, they are forced to them to resort to bank debt and public equity. These sources of funding tend to be more expensive.
The pecking order implied by the theory is the following. Companies will prefer to use internal financing first, then debt, and finally new equity. Thus, raising new equity is the option of last resort.
The optimal capital structure
The pecking order theory of capital structure implies that the optimal capital structure is driven by companies’ preference for different types of financing. This preference in turn is largely driven by the cost of the different sources of financing. In particular, investors will demand a higher rate of return when there is more uncertainty on the prospects of the company. Thus, the less information investors have (the higher the degree of asymmetric information), the higher the required rate of return they will demand.
This asymmetric information is lowest for the management of the company. Clearly, they know most about the company’s financial position. This implies that internal financing must be cheapest, so it is the preferred type of financing. Next, debt is preferred over equity.
The reason why this is the case, is the following. When management issues new financing by issuing new shares, it may signal that management thinks the stock is overvalued. Similarly, issuing new debt can be interpreted as indicating that management thinks the stock price is undervalued. Thus, a management that announces that it intends to finance projects by issuing new shares will trigger a share price drop.
Pecking order theory example
As an example to the pecking order, consider a company that has a project of $50,000,000 which it needs to finance. It can use $10,000,000 of internal financing which is currently on a current account yielding no interest. Thus, this is the cheapest source of funding since no risk premium has to be paid. Second, the company can also raise debt. If the company raises debt, it will have to pay an interest rate of 6%. Finally, the company can also issue new equity. The required rate on equity is 12%. Clearly, equity holders have a residual claim. Thus, they require a higher rate of return than debt. Still, even if the required rates of return on debt were the same, a company would still prefer debt. This is because issue new shares would be interpreted by investors as a sign that the stock is currently overvalued. This explains why companies typically use considerable amounts of debt and prefer debt over equity.
Summary
We discussed the pecking order theory of the capital structure, which explains why companies favor the use of debt over equity. This is consistent with companies strong reliance on debt in practice.