The pecking order theory or pecking order model explains how companies prioritize financing sources for an optimal capital structure choice, while balancing long-term debt and equity financing.
Managers following this corporate finance model follow a hierarchy while investing in opportunities. They prioritize using internal funds or retained earnings before exploring other options. Debt is the next option once they exhaust internal financing.
Equity financing is their last resort when debt doesn't seem viable anymore.
The pecking order theory of capital structure states that company managers prioritize companies' financing operations based on a hierarchy where they first use retained earnings (internal financing), then debt financing, and equity financing at last.
Financial analysis software and financial risk management software play a significant role in how companies analyze their cash flow and financial economics to find sources of financing. Myers and Majluf popularized the pecking order theory to help businesses make sound financing decisions.
Internal financing is the first choice in the pecking order theory because there is no extra cost associated with using it. Companies using retained earnings for financing don't have to pay debt or equity costs.
Debt financing comes in second because of the interest payments associated with using debt capital. Whether the company takes out business loans or issues corporate bonds, it will have to pay some interest, making the cost of debt more than the non-existent cost of using retained earnings.
Equity financing comes last in the pecking order theory because it affects profitability and is the most expensive option. The cost of equity capital—for example, stock shares—is higher than the cost of debt financing.
Investors often see share issuance as a telltale sign of a higher share valuation than the market value. They treat this signal as an indicator of soon-to-drop share prices.
This misunderstanding happens because of asymmetric information, the core idea behind the pecking order theory. Asymmetric information or information failure takes place when one party or individual has more information than the other party or individual.
Managers know more about company performance, prospects, future outlook, or risks than creditors, investors, debt holders, or shareholders. Because of this knowledge imbalance, external users demand a higher cost of capital to counterbalance the risk. When firms issue equities for financing, they end up paying more because of this information asymmetry.
The ultimate goal is to use the trade-off theory to optimize the firm’s capital structure which creates the right balance between debt, equity, and other determinants.
Imagine you are a company manager deciding how to finance an exciting new project. You've calculated the costs, and you will need $15,000 to put this idea into action. You have three options.
Option 1: If you have $15,000 retained earnings, you can finance this project using only internal financing. Congrats! You don't need to seek out any external funding.
When you don't have enough retained earnings, you seek debts.
Option 2: According to the pecking order theory, your next move would be to seek debt financing.
If you opt for a short-term loan of $15,000 with an interest rate of 5%, you’ll pay $750 in interest or $15,750 in total. Repaying the loan will be more expensive than using internal funds.
Option 3: As a company manager, you might conclude that debt financing isn’t ideal because lenders don’t have the debt capacity or you aren’t sure your company will have enough net debt after paying the money it borrows.
You may also want to improve the company’s debt ratios. Better to catch these debt issues beforehand—you wouldn't want to go bankrupt! Now, you can use equity financing and issue equity to get that $15,000 you need.
If your company's stock price is $30 per share, you'd need to sell 500 shares to gain $15,000 in debt capital. However, this decreases your share price by, let's say, $2 per share, making each share worth $28. That means you're giving up an extra $2 per share (or $1,000 total) when you sell those 500 shares.
You would get the $15,000 right away but end up paying more dividends ($16,000 in total) when factoring in the cost of new equity.
While you can explain the pecking order theory in terms of how much each type of financing costs, to understand it truly, 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 little room for differing information between a company and itself, so there is no risk in using those internal finances.
External financing comes next—first, corporate debt financing, then equity financing. Debt investors don't know everything that's going on behind the scenes, but they can be pretty sure about debt repayment. Thus, they are at less risk than equity investors (remember, issuing additional equity gives a wrong impression as it makes company stock look overvalued).
Stockholders 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.
You can only use the pecking order theory when you understand a company's finances. Gathering and analyzing financial data can be stressful without the right tool. Companies use financial analysis and risk management solutions to track, manage, and analyze finances.
Financial analysis tools help companies monitor financial performance. These solutions gather and analyze financial transactions and accounting data to help you stay on top of key performance indicators (KPIs) and make wise financial decisions. Accountants also use these systems for report generation and financial compliance purposes.
Financial risk management systems aid financial services institutions in spotting and mitigating investment risks. These tools play a key role in how companies simulate investment scenarios, conduct in-depth analyses, and find suitable investment opportunities.
The pecking order theory explains how and why companies choose between internal financing, debt, and equity to finance their businesses. The theory doesn’t guide decision-making despite its usefulness in financial management based on capital structure decisions.
Plus, there’s no quantitative metric that shows you how to analyze or calculate financing sources. Consider using the pecking order theory with other tools to drive sound capital market decisions.
Leverage best-in-breed financial predictive analytics software solutions to drive investment strategy with historical data analysis.
This article was originally published in 2019. It has been updated with new information.
By analyzing financial performance with financial analysis software.
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