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.
Pecking order theory starts with asymmetric information as managers know more about their company’s 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. Therefore, there 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 board’s confidence that an investment is profitable and that the current stock price is undervalued (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.
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 structure. However, several authors have found that there are instances where it is a good approximation of reality. Zeidan, Galil and Shapir (2018) document that owners of private firms in Brazil follow the pecking order theory, and also Myers and Shyam-Sunder (1999) find that some features of the data are better explained by the pecking order than by the trade-off theory. Frank and Goyal 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.
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.
Internal funding/ financing comes from retained earnings a company has. Why do the CFOs prefer internal funding? Because it is easier to raise funding, the initial funding setup costs are almost zero because no bankers are involved. Even though internal financing is pretty easy and simple, there are reasons why it might not be preferred. One is that the risk transfer of losses still stays with the company.
External financing can be of two types. By taking the requisite budget as a loan or selling a part of the company’s share as equity. There is an entire discussion on choosing an optimum capital structure that can help the company minimize the cost of capital and maximize the risk transfer. However, that discussion is out of scope for this article, which will be discussed separately in another article. Now, let us dwell on details about each type of funding.
No chief of a company would want to sell a part of their company unless deemed necessary. However, there are cases where the only way to raise money is by selling the company. Be it a failure of the company to raise money through debt, or be it the inability of a company to maintain enough portfolio to raise money through bank loans, the company can always sell a part of itself to raise money.
One great advantage of equity financing is that it is not risky. It is completely dependent on the buyer to own a share of the company, and the risk transfer is a hundred percent in this case. The company has no obligation to pay the shareholder anything.
POT says that the order in which the company tries to raise funding is:
Internal Financing -> Debt -> Equity.
As the name says, debt funding is where the company raises the required amount through a loan either by selling bonds if the company wants to raise loans in a tradeable market or by pledging assets if the company wants to raise loans through the banking system. Each of these ways has its own merits and demerits on how to raise a loan. Raising through markets will give the company to choose their interest rates and price their bonds accordingly.
The company will also have the flexibility to buy back the bonds if it wants to or create a bond structure that supports its operational structure. However, bonds are not ideal if the company wants to ensure the funding. Many things could go against the company while raising money from bonds. However, even though it is a bit expensive and the company has to pledge assets, raising money through bank loans guarantees that the money will be raised.