🧠 What Is the Pecking Order Theory?
Imagine you own a lemonade stand. You want to grow it — maybe buy a fancier stand, or advertise more. You need money to do that. But where should that money come from?
The Pecking Order Theory, developed by Myers and Majluf (1984), says that companies follow a preference order (or pecking order) when choosing how to fund things.
Just like chickens in a coop have a pecking order — who eats first — companies have a financial pecking order too.
🪜 The Financial Pecking Order
According to this theory, companies prefer to finance their operations in the following order:
-
Internal Funds (Own money)
First choice is always retained earnings — the profits a company has saved up. Like you using the money in your piggy bank to upgrade your lemonade stand. -
Debt (Borrowed money)
If internal funds aren’t enough, companies will borrow money. Like asking your parents for a loan — but you’ll need to pay them back with interest. -
Equity (Selling ownership)
The last choice is selling shares or ownership in the company. This is like letting your neighbor buy 30% of your lemonade stand. You get money, but you lose some control.
💡 Why This Pecking Order?
Here’s the big idea: Information asymmetry.
-
The managers of a company know more about it than outside investors.
-
If they try to issue shares (equity), investors might think: “Why are they selling ownership? Is something wrong?”
-
This can drive share prices down.
-
So companies avoid equity unless they have no other option.
📝 (Myers & Majluf, 1984, as cited in Frank & Goyal, 2003)
🏢 Real-World Example
Example 1: A Tech Startup
-
It makes a $500,000 profit.
-
Wants to invest in a new app feature costing $600,000.
-
It uses the $500,000 (internal funds) and borrows $100,000 from a bank (debt).
-
It avoids selling shares to new investors unless there’s no choice.
Example 2: Apple Inc.
-
Apple often has billions in retained earnings.
-
It prefers to use those funds rather than issuing more stock.
-
This keeps control with existing shareholders and avoids share dilution.
🔍 Comparison with MM Theory
While Modigliani and Miller (1958) assumed that capital structure doesn't matter in a perfect world, the Pecking Order Theory accepts imperfections — especially information gaps between managers and investors.
So:
-
MM says: “Capital structure doesn’t matter under ideal conditions.”
-
Pecking Order says: “In the real world, companies prefer internal funds, then debt, then equity.”
✅ Strengths of the Pecking Order Theory
-
Explains real behavior: Many firms do prefer internal funding.
-
Acknowledges real-world conditions: Information asymmetry, transaction costs, signaling.
-
Avoids equity dilution: Keeps control with current owners.
❌ Criticisms and Limitations
-
Doesn’t explain target debt ratios: Many firms do seem to aim for a balanced debt-to-equity mix.
-
Assumes internal funds are always available: Startups and struggling firms may not have this luxury.
-
Doesn’t consider tax advantages of debt: Other theories like the Trade-off Theory focus on tax shields.
🧾 Summary Table: Pecking Order vs. Other Theories
| Theory | Key Idea |
|---|---|
| MM Theory | Capital structure irrelevant in a perfect market |
| Pecking Order Theory | Firms prefer internal funds > debt > equity |
| Trade-off Theory | Firms balance tax benefits of debt vs. bankruptcy cost |
📚 References (APA Style)
-
Frank, M. Z., & Goyal, V. K. (2003). Testing the pecking order theory of capital structure. Journal of Financial Economics, 67(2), 217–248. https://doi.org/10.1016/S0304-405X(02)00252-0
-
Myers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), 187–221. https://doi.org/10.1016/0304-405X(84)90023-0
0 Comments