Pecking Order Theory: Companies prioritize their sources of financing

Modigliani and Miller (1958, 1963) are regarded as the fathers of the modern theory corporate’s financial structure by putting a valuable framework on the possibilities of arbitration on the financial market. In order to pursue this concept, almost 20 years later, the Pecking Order Theory, firstly occurred by Donaldson, was popularized by Myers & Majluf in 1984 and still remains until today one of the most influential theory of corporate finance.

The Pecking Order Theory suggests that firms follow a specific order to choose their capital sources when funding is needed. As a result, they will prefer internal financing through retained earnings. If internal funds are unavailable or not enough, the company will choose external sources of finance and more specifically debt over equity. Equity is seen as the last resort.

(Internal Financing > Debt > Equity)

Internal funding is mainly used because there are no issuance costs (which makes it the cheapest option) and it requires no private information to share. Nevertheless, companies do not always have the required financial resources that is why they use external sources. The most preferable way of external financing is the issuing of new debt which will increase the proportion of debt in the capital structure and will lead to a tax shield. As a consequence, the WACC will be reduced. But increasing the leverage on the capital structure can become extremely risky after a certain point and this is when the company has to turn to equity financing and issue new equity shares on the market.  

For external sources, the Pecking Order Theory deeply focuses on the asymmetry of information. Managers have normally more information about the company’s performances, value and risks than investors and creditors. Depending on the field in which the company evolves, the asymmetry of information can be higher for instance for high technical and complex product. Therefore, creditors and investors will demand higher returns to finance companies because they have a lack of information.

The choice of finance also sends some signals to the markets. Indeed, if a company finances itself internally, it means it is strong and profitable with durable financial resources and may have lower debt-equity ratios. 

Otherwise, if the firm chooses debt financing, that shows the company’s faith to meet the demands of creditors by paying the fixed fees.

Finally, if equity financing is chosen, the majority of investors will probably hypothesize that the firm is currently overvalued which will hurt not only the reputation of the firm but also its economic sustainability.