Updated July 10, 2023
What is Pecking Order Theory?
The term “pecking order theory” refers to the capital structure theory that states that businesses follow a specific hierarchy of financing sources wherein they prefer internal financing if available, followed by debt, and finally, equity financing kicks in.
This theory is one of the most important theories of corporate finance for determining capital structure. The form of financing a firm chooses can signal how well it performs.
How Does Pecking Order Theory Work?
According to the pecking order theory, firms prioritize using retained earnings to finance their investment requirements. Then, if the internal resources are insufficient, they prefer to finance the capital needed with debt, and, finally, if nothing works, they go for equity infusion.
This pecking order is critical as it indicates how the company is performing. For example, if a company can finance its requirements internally, it is doing well. On the other hand, if a company opts for debt financing, it indicates that management is certain of good results and can comfortably meet its obligations. Finally, if a company has to rely on equity financing, it may send a negative signal.
Examples of Pecking Order Theory
Let us assume that Chandler is a company manager responsible for deciding the sources of finance for an exciting new project. He has calculated the costs, and his estimates indicate that a fund worth $100,000 will be needed to implement this idea.
If the company can fund the project internally with retained earnings, it doesn’t need to seek external funding. So, the company will take away $100,000 from the retained earnings and fund the project.
However, if the company doesn’t have enough retained earnings to fund the project, the next move, according to the pecking order, will be to seek debt financing. Borrowing $100,000 from a bank at an interest rate of 6.5% for three years, the company will pay $19,500 or $119,500. This is not as ideal as simply paying $100,000 out of internal funding.
If the company feels debt financing isn’t the ideal option, it isn’t sure whether the project will generate enough cash to pay back the money in just three years. Then the next option in the pecking order will be equity financing. In this case, the company has to issue new equity shares to bring funds. For example, if the company shares are priced at $10 per share, it must sell 10,000 to infuse $100,000 of equity capital. However, this will dilute the share price sending a negative signal to the shareholders and other company stakeholders.
So, these are the possible funding options available to Chandler. Of course, he will probably follow the pecking order and choose the option that suits the company’s interest. Nevertheless, this is how pecking order dictates the capital structure decision in real life.
Assumption of Pecking Order Theory
The pecking order theory assumes that there is no target capital structure and that companies prioritize their financing strategies based on the path of least resistance. The theory also assumes an asymmetry of information between the manager and the investors, which means the company managers have access to information that the investors don’t know about.
In the pecking order theory, companies determine their financial strategy based on the seniority of claims to assets. Equity stockholders enjoy higher returns than debtholders due to the latter’s stronger asset claim in bankruptcy. Consequently, the sources of financing are arranged in the following sequence: retained earnings are the cheapest, followed by debt and equity.
Advantages of Pecking Order Theory
Some of the major advantages of the pecking order theory are as follows:
- First, it is a useful theory that guides in verifying how information asymmetry affects the financing cost.
- It helps companies decide the optimal way to raise funds for financing corporate strategies, such as a new project.
- It shows how the company managers are eager to maintain control of the firm.
Disadvantages of Pecking Order Theory
Some of the major disadvantages of the pecking order theory are as follows:
- First, the theory focuses on a very limited number of variables while determining the effect on the cost of financing.
- It doesn’t provide any quantitative estimate of the impact of information flow on the cost of financing.
Key Takeaways
Some of the key takeaways of the article are:
- According to the pecking order theory, businesses prioritize internal and debt financing. Then equity financing is the final option.
- The choice of financing source is very important as it indicates to the public how well the firm is performing.
- The theory assumes no target capital structure and information asymmetry between the company’s managers and the investors.
Conclusion
So, it can be seen that the pecking order theory is associated with the capital structure of businesses, wherein it explains why and how companies decide on different finance sources between internal financing, debt, and equity. The theory arises from information asymmetry and explains why equity financing is the costliest and should be the last resort for financing.
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