Pecking Order Theory: Understanding Capital Structure and Funding

The pecking order theory suggests that firms prefer to finance their investments internally, rather than through external sources like debt or equity. This is because internal financing is less costly and less risky.

Firms tend to use internal funds first, followed by debt, and finally equity. This is because debt is considered safer and more controllable than equity.

The pecking order theory was first introduced by Stewart Myers and Kevin Murphy in 1986.

Recommended read: What Is a Loan Covenant

Pecking Order Theory is a financial theory that explains how companies prefer to finance their projects in a specific order.

Companies prefer to finance new projects using retained earnings first.

Retained earnings are essentially the profits a company has made that it decides to keep within the business.

This is because retained earnings are considered the safest and most cost-effective source of financing.

Debt financing comes next in the pecking order, where companies issue debt to raise funds.

Equity financing is the last resort, used when debt is not an option.

The key reason behind this hierarchy is to avoid information asymmetry, signalling, and financial risk.

You might enjoy: Internal Financing

The pecking order theory is a framework used to understand the preferences of companies when selecting the type of financing. It was first identified by Donaldson in 1961 and further developed by Myers and Majluf in 1984.

The theory proposes that firms abide by a hierarchical order in their financing decision, prioritizing internal funds, debt financing, and equity financing in that order. This hierarchy is based on the notion that companies prefer to use internal funds first, as they are the cheapest source of financing.

Internal funds, also known as retained earnings, are the accumulated profits retained by a company to date, not issued to shareholders as dividends. Companies prioritize internal funds because they are the cheapest source of financing, with no interest or principal payments required.

Debt financing is the second preference, where companies borrow capital from lenders such as banks, with periodic interest payments and a return of the principal at maturity. Debt financing is cheaper than equity financing, but still involves a cost.

A fresh viewpoint: Owner Financing in Real Estate

Equity financing is the costliest and should be used as a last resort to obtain financing. It involves issuing shares, which represents partial ownership stakes in the issuer's common equity, and comes with a higher cost as businesses must share their profits with shareholders.

Here is a summary of the pecking order theory's hierarchy of financial sources:

This hierarchy helps guide financial decisions, with a focus on cost efficiency and risk minimization. By prioritizing internal funds, debt financing, and equity financing, companies can effectively balance their financial risk and structure their capital.

For another approach, see: Equity Debt Financing

The pecking order theory has a significant impact on a company's capital structure. The theory suggests that companies prefer to rely on internal funds rather than external financing, such as debt and equity.

Internal financing is the first choice because it's free, and there's no extra cost associated with using retained earnings. Companies using retained earnings for financing don't have to pay debt or equity costs.

Debt financing comes in second because of the interest payments associated with using debt capital. The cost of debt is lower compared to the cost of equity, making it a more attractive option for companies.

Equity financing comes last in the pecking order theory because it affects profitability and is the most expensive option. The cost of equity capital is higher than the cost of debt financing, and investors often see share issuance as a telltale sign of a higher share valuation than the market value.

The pecking order theory also highlights the importance of historical profitability as one of the core determinants of a company's capital structure. More profitable firms have the option to rely more heavily on internal financing.

Here's a summary of the pecking order theory's cost hierarchy:

The pecking order theory implies that a corporation's financing decision is far more nuanced than merely maximizing the firm value. Managers can access more information on the company's financial condition and expected operating performance relative to external stakeholders, influencing their financing decisions.

The pecking order theory highlights the cost hierarchy among different financing sources, which directly influences the order of preference. Companies prefer to rely on internal funds rather than external financing, such as debt and equity.

Internal financing is the first choice because there is no extra cost associated with using it. Companies using retained earnings for financing don't have to pay debt or equity costs. This makes sense, as it's like using your own savings to fund a project.

Debt financing comes in second because of the interest payments associated with using debt capital. Whether the company takes out business loans or issues corporate bonds, it will have to pay some interest, making the cost of debt more than the non-existent cost of using retained earnings.

The cost of equity capital, for example, stock shares, is higher than the cost of debt financing. This is because investors often see share issuance as a telltale sign of a higher share valuation than the market value.

For your interest: Mortgage Interest Rate

The pecking order theory suggests that companies prefer debt over equity because debt offers lower information costs. This means that managers can access more information on the company's financial condition and expected operating performance relative to external stakeholders.

Here's a breakdown of the cost hierarchy:

Overall, the pecking order theory emphasizes the importance of considering the costs and benefits of different financing sources when making financial decisions. By understanding the cost hierarchy, companies can make more informed decisions that reflect the best interests of the firm.

For your interest: Exploring Credit Inquiry Solutions for Smarter Financial Decisions

The pecking order theory has its fair share of advantages and disadvantages. One of the key benefits is that it allows for cost minimization, which is a major plus for businesses looking to save money.

The theory also offers flexibility, which means companies can adjust their financing strategies as needed. This is particularly useful in uncertain economic times. Ownership preservation is another advantage, as it allows companies to maintain control over their operations.

The pecking order theory is also a realistic behavior model, meaning it reflects how companies actually behave in the real world. Additionally, it considers information asymmetry, which is a crucial factor in decision-making.

However, there are also some significant drawbacks to the pecking order theory. One major con is that it can lead to a suboptimal capital structure, which can be detrimental to a company's long-term success.

Other disadvantages include missed market discipline, overreliance on debt, underinvestment, cash hoarding, and agency problems. These issues can have serious consequences for a company's financial health and overall performance.

Here are the key pros and cons of the pecking order theory:

Apple Inc. traditionally avoided issuing debt or equity, instead relying on its internal funds, reflecting the principles of the Pecking Order Theory. This reduced financial costs and enabled them to finance massive investments in technology, design, and marketing.

The Pecking Order Theory is not a one-size-fits-all approach, as seen in the example of Tesla Inc., which initially deviated from the theory due to minimal retained earnings. As the company matured and began accruing more significant retained earnings, it started to follow the Pecking Order Theory more closely.

A high-growth SaaS company in the article example required $50 million to fund a major expansion project, and it first used its internal resources, allocating $20 million in excess cash to the project. This decision enabled the company to fund a significant portion of the project without incurring additional costs or scrutiny from external stakeholders.

The SaaS company's decision to raise debt financing next, securing a bank loan package for $25 million at a 5% interest rate, was a strategic approach to minimize its overall cost of capital post-financing. This also preserved some debt capacity for future financing needs, maintaining financial flexibility.

Tesla Inc.'s shift towards following the Pecking Order Theory more closely is an example of conditional applicability of the theory, which depends on the firm's stage of evolution, its industry, and its operating environment.

Broaden your view: Final Decision

To make the most out of the pecking order theory, consider using it in conjunction with other tools to drive sound capital market decisions.

Leverage best-in-breed financial predictive analytics software solutions to drive investment strategy with historical data analysis.

Debt can be scary, especially when paying off college loans.

The pecking order theory doesn't provide a quantitative metric to analyze or calculate financing sources.

Here's an interesting read: Drive Theory

The Pecking Order Theory is a useful framework for making smart financial decisions. It guides companies on how to choose between internal financing, debt, and equity to finance their businesses.

By following the pecking order, companies can minimize their overall cost of capital post-financing relative to their cost of capital if they had gone straight to issuing equity. This strategic approach also preserves some debt capacity for future financing needs, maintaining financial flexibility.

Companies start with their internal resources, such as retained earnings, which is the least costly and most preferred source of funds. In fact, a SaaS company in Example 1 was able to allocate its entire excess cash balance of $20 million to a project without incurring any additional costs.

Debt is the next preferred option, as it provides tax advantages and is easier and more cost-effective than issuing equity. A SaaS company in Example 1 was able to secure a bank loan package for $25 million at a 5% interest rate given its favorable position.

Additional reading: Fixed vs Variable Cost

Equity is the last resort, as it comes with a higher cost and involves dilution of ownership and control. However, a start-up technology company in Example 6 might resort to issuing equity if its retained earnings and debt options are insufficient or unavailable.

Here's a summary of the pecking order hierarchy:

By understanding the pecking order theory and its hierarchy of financing options, companies can make informed decisions and minimize their financial risks.