Pecking Order Theory

In the theory of firm's capital structure and financing decisions, the Pecking Order Theory or Pecking Order Model was developed by Stewart C. Myers in 1984. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not 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.

Evidence

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. On the one hand, Fama and French [ [http://rfs.oxfordjournals.org/cgi/content/abstract/15/1/1 Testing Trade-Off and Pecking Order Predictions About Dividends and Debt, Review of Financial Studies, 2002] ] , and also Myers and Shyam-Sunder [ [http://www.inomics.com/cgi/repec?handle=RePEc:nbr:nberwo:4722 Testing static trade-off against pecking order models of capital structure, Journal of financial Economics, 1999] ] find that some features of the data are better explained by the Pecking Order than by the Trade-Off Theory. Goyal and Frank 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. [ [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=243138 Testing the pecking order theory of capital structure, Journal of Financial Economics, 2003] ]

Profitability and debt ratios

The Pecking Order Theory explains the inverse relationship between profitability and debt ratios:

1) Firms prefer internal financing.

2) They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends.

3) 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.

4) 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.

ee also

*Capital Structure
*Corporate Finance
*Cost of capital
*Market timing hypothesis
*Trade-Off Theory

References