# Pecking Order Theory

## Core Proposition

Firms prefer to issue debt when positive about future earnings. Equity is issued only when managers are doubtful and internal finance is insufficient.

The theory argues that capital structure decisions are affected by managers' choice of a source of capital that reveals the least amount of information (information asymmetry between insiders and outsiders).

## The Pecking Order (Hierarchy)

Priority	Source	Reason
1st	Internal Finance (retained earnings)	No information signalling; no flotation cost
2nd	Debt (secured -> unsecured -> hybrid)	Limited information disclosure; tax shield
3rd (last)	New Equity Issue	Sends negative signal; highest issuance cost

## The Three Rules

Rule 1: Use internal financing first.
Rule 2: Issue debt next.
Rule 3: Issue new equity shares at last.

## Why Equity is Last

Issuing new equity sends a negative signal to the market — investors infer that the stock may be overvalued, causing share price to fall. Managers therefore avoid equity issues except as a last resort.

Worked example

### Example 1

Decision Scenario: A profitable firm needs Rs. 50 crore for expansion. Following pecking order:

Step 1 — Check retained earnings: Rs. 30 crore available -> use this first.

Step 2 — Remaining Rs. 20 crore: raise via debt (secured loan from bank).

Step 3 — Equity is avoided to prevent a negative market signal.

⚠️ Common exam mistakes

Confusing pecking order with the trade-off theory — pecking order has no 'target' capital structure
Forgetting that information asymmetry is the central driver of the theory
Treating the order as a strict ranking when in practice managers may deviate based on market conditions

Reference:

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