Capital Structure Considerations

Pecking Order

The pecking order of investors or credit holders in a company plays a part in how the company decides to structure its capital. Pecking order theory states that the cost of financing increases with asymmetric information. Financing comes from internal funds, debt, and new equity. When it comes to methods of raising capital, companies prefer internal financing, debt, and then issuing new equity. Raising equity, in this sense, can be viewed as a last resort.

Stewart C. Myers (1940– ) popularized the pecking order theory, arguing that equity is a less preferred means of raising capital because managers issue new equity (who are assumed to know better about the firm's true conditions than investors). Investors believe that managers overvalue the firms and are taking advantage of this overvaluation.

As a result, investors will place a lower value on the new equity issuance. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external funding is required. Thus, the form of debt a firm chooses can act as a signal of its need for external finance. This sort of signaling can affect how outside investors view the firm as a potential investment and, once again, must be considered by the people in charge of the firm when making capital structure decisions.

Tests of the pecking order theory have not shown that it is of first-order importance in determining a firm's capital structure. However, several authors have found that there are instances where it is a good approximation of reality. On the one hand, Fama, French, Myers, and Shyam-Sunder find that some data features are better explained by the Pecking Order than by the trade-off theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry is presumably an important problem.