Pecking Order Theory | Definition + Finance Example

Table of Contents

What is Pecking Order Theory?
How Does the Pecking Order Theory Work?
How Does Pecking Order Theory Impact Capital Structure?
Pecking Order Theory: Cost Hierarchy Structure
Pecking Order Theory: What are the Pros and Cons?
Pecking Order Theory: Corporate Finance Example

What is Pecking Order Theory?

The Pecking Order Theory outlines a hierarchical structure by which corporations abide by that dictates their funding sources (and capital structure).

In simple terms, the pecking order theory states that financial managers have a preference to fund their operations with internal funds, followed by debt financing and then equity financing as a last resort.

Pecking Order Theory

How Does the Pecking Order Theory Work?

The pecking order theory, pioneered by Stewart Myers and Nicolas Majluf in 1984, proposes that firms abide by a hierarchical order in their financing decision.

Traditional capital structure theories, such as the optimal capital structure theory, are based on the premise that corporations adjust their capital structure to optimize their mix of debt and equity to reduce their cost of capital (WACC), which maximizes their respective valuation.

In contrast, the pecking order theory is predicated on the notion that the hierarchy by which companies prioritize their financing sources stems from information asymmetry between a company’s managers and external stakeholders.

The pecking order theory is closely intertwined with the concept of asymmetric information, which is the occurrence wherein one party possesses more information relative to other market participants (i.e. an imbalance of knowledge). Therefore, information asymmetry is perceived as one of the core determinants of a firm’s financing decision.

The costs attributable to each financing method are also deemed to be factors that contribute toward the decision-making process of financial managers to fund operations.

The pecking order theory states that companies prioritize their financing sources based upon a particular hierarchy, as outlined in the following list ordered by descending priority.

Internal Funds (Retained Earnings) ➝ The accumulated profits retained by a company to date, not issued to shareholders as dividends.
Debt Financing ➝ The capital borrowed from lenders such as banks as part of a financing arrangement, where the borrower is obligated to pay periodic interest to the lender and return the principal in full at maturity.
Equity Financing ➝ The capital raised via issuances of equity, or shares, which represent partial ownership stakes in the issuer’s common equity.

How Does Pecking Order Theory Impact Capital Structure?

In practice, financial managers prefer to rely on internal funds rather than external financing, such as debt and equity.

External funding is thereby raised by a company under the condition that the decision is deemed necessary, per the pecking order theory.

Of the two sources of external financing, debt is preferred over equity by most companies because debt offers lower information costs (i.e. insights that others lack).

Hence, the issuance of equity is viewed as a last resort under the theorized financing hierarchy behavioral pattern, where the incentive is the avoidance of the wealth transfer to outsiders and the negative effect of adverse selection inherent to external funding sources.

The pecking order theory—in contrast to the optimal capital structure theory—implies that a corporation’s financing decision is far more nuanced than merely maximizing the firm value.

In short, the pecking order theory recognizes that managers can access more information on the company’s financial condition and expected operating performance relative to external stakeholders, influencing their financing decisions.

The capital structure of a company, or the mixture of debt and equity used to fund operations, is a rather intricate subject, contingent on the cumulative financing decisions over time and management’s unique perspective.

Hence, the observed capital structures of companies frequently deviate from the optimal capital structure that should be targeted, contrary to the theories taught in academia (i.e. mismatch between economic theory and reality).

The theory also highlights the importance of historical profitability as one of the core determinants of a company’s capital structure, as more profitable firms have the option to rely more heavily on internal financing (and simultaneously, external financing is more readily available at more favorable terms).

The pecking order theory’s emphasis on information asymmetry is far-reaching in scope for analyzing a company as an external stakeholder.

The financing decisions of a company could be a signal to the market regarding its near-term (or long-term) outlook concerning revenue growth, profitability, and operating performance.

The signaling effect creates another layer of complexity to financial decision-making because management must consider not only the direct costs of financing but also the potential market reactions to their choices (i.e. their decisions can have long-term consequences on the company’s stock price).

Pecking Order Theory: Cost Hierarchy Structure

The pecking order theory operates on several fundamental principles of corporate finance, with information asymmetry at its core.

Under the implicit assumption that managers have more information about the company’s intrinsic value and prospects than outsiders–such as equity investors and lenders—the information gap significantly influences financing choices, as managers strive to make decisions that reflect serving the “best interests” of the firm.

Furthermore, investors and other market participants can interpret those internally-made decisions as signals about the firm’s prospects, which influences the market sentiment and thus stock price at which its shares trade in the open markets.

The theory suggests a cost hierarchy among different financing sources, which directly influences the order of preference:

Source of Financing	Description
Internal Financing	Internal financing, most often in the form of retained earnings, accumulated cash reserves, or asset sales, is considered the most preferred source. Internal financing represents the cheapest and most readily available source of funding, avoiding the transaction costs and market scrutiny associated with external financing. However, too much reliance on internal financing may lead to fluctuations in dividend policies and cash holdings, as companies must balance their financing needs with shareholder returns.
Debt Financing	When internal funds prove insufficient, companies turn to debt financing as the next preferred option. Debt is deemed favorable over equity because of the lower cost (i.e. cost of debt) and potential tax benefits since interest is tax-deductible (i.e. “tax shield”). The most common forms of debt financing raised by corporations include bank loans, bonds, and lines of credit, like a revolving credit facility (or “revolver”). The preference for debt is based on several factors: interest payments are tax-deductible, lowering the effective cost of debt. Unlike equity, debt does not dilute the existing ownership structure, which directly impacts the value of each existing share. The issuance of debt can send a more positive signal to the market than issuing equity since only profitable companies can meet debt obligations (e.g. mandatory amortization, interest expense). However, companies must balance the benefits tied to debt against the increased financial risk and potential for bankruptcy that comes with higher leverage.
Equity Issuance	Equity issuance is considered the least preferred option and is typically used as a last resort. The preference stems from several factors, like the high transaction costs associated with new equity issuances (i.e. hiring a 3rd party advisor, like an investment bank), the potential negative market reaction, as the market might perceive that the company believes its shares are overvalued, as opposed to undervalued (i.e. the ideal market reaction), and the dilution of existing shareholders’ ownership and earnings per share (EPS). The reluctance to issue equity helps explain why many large, profitable companies prefer to maintain low debt levels despite the potential tax benefits of higher leverage, as such firms can rely more heavily on internal financing and avoid the need for external equity.

Pecking Order Theory: What are the Pros and Cons?

The advantages of the pecking order theory are as follows:

Pros	Description
Cost Minimization	The theory provides a framework for minimizing financing costs by prioritizing cheaper sources of capital (and consideration toward information costs).
Flexibility	Companies can adapt their financing strategies to changing circumstances and available resources, which are particularly valuable in volatile economic environments.
Ownership Preservation	Relying primarily on internal funds and debt helps maintain existing ownership structures and control, which is crucial for certain businesses.
Realistic Behavior Model	The theory often aligns well with observed corporate financing behavior, especially among mature firms, enhancing its applicability in real-world scenarios (i.e. relative to other theories that pertain to the optimal capital structure).
Information Asymmetry Consideration	By accounting for the information gap between managers and investors, the theory offers insights into how financing decisions can signal company prospects to the market.

On the other hand, the disadvantages of the pecking order theory are as follows:

Cons	Description
Suboptimal Capital Structure	The strict adherence to the pecking order might lead to a capital structure that might not maximize firm value or take full advantage of tax benefits associated with debt, among other benefits.
Missed Market Discipline	By avoiding equity issuance, companies might miss out on the disciplining effects of equity markets or the benefits of a more balanced capital structure.
Overreliance on Debt	The theory can potentially lead to excessive debt on the balance sheet, increasing financial risk and the potential for financial distress (i.e. insolvency), especially if market conditions deteriorate rapidly or if the economy enters a recession.
Underinvestment	The deliberate avoidance of equity issuances might cause companies to forgo valuable investment opportunities if other financing sources are exhausted, particularly problematic for high-growth firms.
Cash Hoarding	The preference for internal financing might lead to excessive cash holdings, potentially reducing overall efficiency and returns to shareholders (i.e. opportunity cost of capital).
Agency Problems	Critics argue that cash hoarding behavior could lead to situations where managers retain cash for their interests rather than returning it to shareholders or investing in value-creating projects.

Pecking Order Theory: Corporate Finance Example

To illustrate the practical application of Pecking Order Theory, suppose a high-growth SaaS company requires $50 million to fund a major expansion project to achieve greater profitable growth.

Based on the pecking order theory, the SaaS company starts with its internal resources, where $20 million in excess cash was identified, namely via its retained earnings.

The SaaS company allocates the entire excess cash balance to the project—while still ensuring the cash on hand remains above its minimum cash requirement to fund working capital needs—adhering to the principle that internal financing is the most preferred source of funds.

The decision to rely on internal funds initially enables the SaaS company to fund a significant portion of the project without incurring any additional costs or scrutiny from external stakeholders.

Given the $30 million shortfall in funding (i.e. the remaining gap in financing required), the SaaS business now turns to raise debt financing in the credit markets, as the next preferred option.

Leveraging its low debt-to-equity ratio (D/E) and minimal debt balance in its current capital structure, the SaaS company manages to secure a bank loan package for $25 million at a 5% interest rate given its favorable position — which aligns with the principle of preferring debt over equity when external financing is necessary.

By choosing debt, the company avoids the potential negative signals and dilution associated with equity issuance, while also benefiting from the tax-deductibility of interest payments.

For the remaining $5 million, the SaaS company reluctantly opts to raise equity financing as a last resort.

The risk-averse decision to issue new shares for a relatively small amount demonstrates the company’s adherence to the pecking order, whereby the other options are exhausted before resorting to equity.

The minimal equity issuance could be perceived positively or negatively by the market, which is an external variable that management cannot control but can mitigate the risk to some degree.

The SaaS company must therefore carefully consider the potential stock price impact and dilution effects of the decision.

By following the pecking order, the SaaS company likely minimizes its overall cost of capital post-financing relative to its cost of capital if it had gone straight to issuing equity.

The strategic approach to raise capital in that order also preserves some debt capacity for future financing needs, maintaining financial flexibility (i.e. room to raise debt on a later date).

The increased leverage, however, does raise our hypothetical company’s financial risk — albeit not to an excessive degree given its growth prospects (and business risk), considering the order by which the financing was used as needed.