the pecking order theory

The pecking order theory is a theory of capital structure that suggests firms have a preference for internal financing (retained earnings) over external financing and prioritize debt issuance over equity issuance. The theory was first proposed by Myers and Majluf in 1984 and provides insights into how firms make financing decisions based on information asymmetry and the costs of external financing.

Key principles of the pecking order theory include:

1. Information Asymmetry: The theory assumes that managers have more information about the firm’s prospects and value than outside investors. As a result, external financing, such as issuing equity, may signal negative information about the firm and lead to adverse selection costs. Internal financing, on the other hand, avoids this information asymmetry issue.
2. Preference for Internal Financing: The theory suggests that firms prefer to use internal funds, such as retained earnings, to finance investments and operations. Internal financing is seen as a reliable and low-cost source of capital because it does not require disclosing sensitive information to external investors.
3. Debt Over Equity: When internal financing is insufficient, firms tend to prioritize debt issuance over equity issuance. Debt financing is viewed as less costly in terms of information asymmetry compared to equity financing. Additionally, the tax deductibility of interest payments makes debt financing more attractive.
4. Financing Hierarchy: The pecking order theory proposes a financing hierarchy based on the least to most preferred sources of financing: internal funds, debt, and equity. Firms will exhaust internal funds before turning to debt, and equity issuance is considered a last resort.