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.
Illustration of the Pecking Order Theory
The following diagram illustrates the pecking order theory:
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 (debtholders) 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 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:
- Finance the project directly through retained earnings;
- One-year debt financing with an interest rate of 9%, although management believes that 7% is the fair rate; or
- 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.
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