In the animal kingdom, the strongest rise to the top.
It’s a fact of life, and it’s how the common English phrase “pecking order” originated. Pecking order originally described the way chickens assert dominance over each other, eventually creating a hierarchy of chickens. Now, we use it to describe a hierarchy of anything, from people to finance strategies.
What is pecking order theory?
In corporate finance, pecking order theory is used to help explain how companies decide where to source their financing, and thus it helps explain what drives optimal capital structure, or the ideal balance of debt and equity financing.
Pecking order theory definition
Pecking order theory is the idea that company managers decide how to finance company operations based on a hierarchy where they first use retained earnings (internal financing), then debt financing, then equity financing.
Internal financing is the first choice in pecking order theory because there is no extra cost associated with using it. If a company uses only retained earnings for financing, there is no cost of debt or cost of equity to be accounted for.
Debt financing comes in second because of the interest payments associated with using debt capital. Whether the company decides to take out business loans or issue corporate bonds, they will have to pay some interest, making the cost of debt more than the non-existent cost of using retained earnings.
Equity financing is last in pecking order theory because it is the most expensive financing option. The cost of equity capital—for example, stock shares—is higher than the cost of debt financing.
Issuing shares can indicate that a company’s management believes the shares are overvalued—a signal to investors that they might be in trouble and their share price might be about to drop. This is a case of asymmetric information, the core idea behind the pecking order theory. Let me explain.
How does asymmetric information affect pecking order theory?
Asymmetric information is used to describe a situation between two parties in an economic transaction where one party has more or better information than the other.
While you can explain pecking order theory in terms of how much each type of financing costs, to truly understand it, you must understand how asymmetric information causes the differences in cost.
Retained earnings are the least asymmetric (or most symmetric) form of financing—there is not much room for differing information between a company and itself, so there is no risk involved in using those internal finances.
External financing comes next—first debt financing, then equity financing. Debt investors don’t know everything that’s going on behind the scenes, but they can be fairly sure they’ll be paid back. Thus, they are at less of a risk than equity investors (remember, issuing additional equity gives a bad impression as it makes company stock look overvalued).
Investors expect a higher rate of return based on more asymmetrical information. Less information means a higher risk, and when the risk is higher, the expectation is that the payoff is higher as well.
Pecking order theory example
Imagine you are a company manager in charge of deciding how to finance an exciting new project. You’ve calculated the costs, and you’re going to need $15,000 to put this idea into action.
If you have $15,000 in retained earnings, you can finance this project using only internal financing. Congrats! You don’t need to seek out any external financing.
Let’s say you don’t have quite enough retained earnings to cut it for this project. Your next move according to pecking order theory would be to seek out debt financing. If you borrowed the $15,000 from a bank with an interest rate of 5%, you would end up paying $750 in interest, or $15,750 total. Obviously, this is less ideal than simply paying $15,000 out of your internal finances.
If you’ve been following this article, you know what’s coming next. Equity financing. As a company manager, you might conclude that debt financing is not ideal because you can’t be sure your company will be able to pay back the money it borrowed. Better to catch that kind of thing beforehand—you wouldn’t want to go bankrupt! To get that $15,000 you need using equity financing, you’d need to sell some shares.
If your company’s share price is $30, you’d need to sell 500 shares in order to gain $15,000 in debt capital. However, this will dilute your share price by, let's say, $2 per share, making each share worth $28. That means you’re really giving up an extra $2 per share (or $1,000 total) when you sold those 500 shares. You would get the $15,000 right away but end up paying $16,000 total when factoring in the cost of equity.
What the peck?!
Hopefully this article helped you gain some insight into the reasoning behind different types of financing. If you are in a situation where you can’t decide how to finance your business based on pecking order theory, financial predictive analytics software can help you make a calculated choice.