Pecking Order Theory

Definition

The pecking order theory is a concept in corporate finance that explains the order in which businesses typically prefer to raise capital. It suggests that companies follow a hierarchy when financing their operations and investments, starting with the least risky and least expensive sources of capital.

5 Must Know Facts For Your Next Test

1. The pecking order theory suggests that companies prefer to use internal financing (retained earnings) over external financing (debt or equity) when funding their operations and investments.
2. Companies are more likely to issue debt rather than equity when they need to raise external capital, as debt is seen as less risky and less costly than equity financing.
3. The theory assumes that managers have better information about the company's prospects than outside investors, leading to information asymmetry.
4. Firms are reluctant to issue new equity because they believe their stock is undervalued by the market, which can lead to a decline in the stock price when new shares are issued.
5. The pecking order theory helps explain why some profitable companies with low debt levels still prefer to use retained earnings rather than issuing new equity to fund their activities.

Review Questions

• Explain the key principles of the pecking order theory and how it relates to how businesses raise financial capital.
  • The pecking order theory suggests that businesses have a preferred hierarchy when it comes to financing their operations and investments. This hierarchy starts with the least risky and least expensive sources of capital, such as retained earnings, and then moves towards more expensive and riskier options like debt and equity financing. The theory assumes that managers have better information about the company's prospects than outside investors, leading to information asymmetry. This information asymmetry makes companies reluctant to issue new equity, as they believe their stock is undervalued by the market. As a result, firms prefer to use internal financing (retained earnings) over external financing (debt or equity) whenever possible, and are more likely to issue debt rather than equity when they need to raise external capital.
• Analyze how the pecking order theory helps explain the financing decisions of profitable companies with low debt levels.
  • According to the pecking order theory, even profitable companies with low debt levels may prefer to use retained earnings to fund their activities rather than issuing new equity. This is because the theory suggests that companies are reluctant to issue new equity due to the belief that their stock is undervalued by the market. By using retained earnings, these profitable companies can avoid the potential decline in stock price that may occur when new shares are issued. The pecking order theory helps explain this behavior, as companies prioritize the least risky and least expensive sources of capital, such as internal financing from retained earnings, over more costly external financing options like equity. This preference for retained earnings over equity financing is a key tenet of the pecking order theory.
• Evaluate how the concept of information asymmetry underpins the pecking order theory and influences the financing decisions of businesses.
  • The pecking order theory is fundamentally based on the concept of information asymmetry, where managers have better information about the company's prospects than outside investors. This information asymmetry is a critical factor that shapes the financing decisions of businesses according to the theory. Because managers believe their stock is undervalued by the market, they are reluctant to issue new equity, as they fear it will lead to a decline in the stock price. Instead, they prefer to use internal financing from retained earnings, which is seen as the least risky and least costly source of capital. If external financing is required, the theory suggests that businesses will opt for debt financing over equity, as debt is perceived as less risky than equity. Overall, the pecking order theory highlights how information asymmetry between managers and investors influences the financing hierarchy that businesses follow when raising capital to fund their operations and investments.

Related terms

Asymmetric Information: The situation where one party in a transaction has more or better information than the other, leading to an imbalance of power in the transaction.

Information Asymmetry: The uneven distribution of information between parties involved in a transaction, which can lead to adverse selection and moral hazard.

Financing Hierarchy: The order in which a company prefers to raise capital, starting with the least risky and least expensive sources, such as retained earnings, and moving towards more expensive and riskier options like debt and equity.