Pecking Order Theory

Perking order theory provides additional explanation to optimal capital structure. In short, it states that firms prefer to follow hierarchy of financing. This also referred to as perking order. The preferred order is retained earnings, debt and equity. The internal source of finance (retained earnings) is the most preferred source because it does not involve flotation costs and does not require a disclosure of proprietary financial information. This is followed by external sources, which have debt as preferable external source, followed by equity (preferred stock and than common stock).

Asymmetric information may be the reason why hierarchy of financing is generally preferred over target capital structure maintenance. Asymmetric information refers to the chance that management knows more about current real performance of the firm and future growth projections versus outside investors.

Typically management is expected to have an objective of maximizing shareholders value. And, in such case, as proposed by Steward C. Myers in 1984, asymmetric information could be the reason for the fact that financial managers tend to prefer a hierarchy of financing as opposed to target capital structure maintenance, when making financing decisions.

If management have an opportunity for a worthwhile investment and uses debt as a source of financing, investors typically see it as a signal that management believes that stock is under priced. This leads to increase in value of the stock. This also leads to existing stockholders benefiting from full increase in value. Existing stockholders don’t have to share increase in value with new stockholders.

However, if management issues new stock, investors generally see it as a signal that management believes that stock is over priced and that management believes that current performance and prospects of the firm is seen better by the market than it is in reality (and as known by the management). This leads to decrease in value of the stock. Flotation costs together with decrease in value of stock are variables that contribute to high cost of new stock issue as a source of financing.

Given above, it makes sense for firms to keep low levels of debt. This will allow firms to use debt as a source of financing when good investment opportunity arises but stock is believed by management to be under priced.

If debt level does not allow further borrowing, management will be in unfortunate position. Issuing of new stock will send the wrong signal to the market (that stock is over priced). This will further decrease the value of already believed to be under priced stock.

Two surveys were conducted, one with Fortune 500 companies and another with large OTC (over-the-counter) companies, which support pecking order theory. Both surveys point out that, in practice, financial managers seem to prefer hierarchy of financing to target capital structure maintenance when making financing decisions.

Results of the surveys presented below:

Authors of surveys Surveys Percentage of responders who prefer using target capital structure when making financing decisions Percentage of responders who prefer using hierarchy of financing when making financing decisions
J.M.Pinegar and L.Wilbricht Fortune 500 Firms 31% 69%
L.C.Hittle, K.Haddad and L.J.Gitman Large OTC Firms 11% 89%

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