Pecking Order Theory

## Pecking Order Theory

### Foundation: Asymmetric Information

Managers know more about the firm's true value and prospects than outside investors. This information asymmetry drives the order in which firms prefer to raise funds.

### The Pecking Order (Myers)

```

1st Choice: Internal Financing (Retained Earnings)

2nd Choice: Debt (Secured → Unsecured → Hybrid)

3rd Choice: Equity (Last Resort)

```

### Why This Order?

#### Internal Financing (Preferred Most)

• No transaction/issue costs — no underwriting fees, brokerage, etc.
• No tax on retained earnings (unlike dividends which come from after-tax profits and may attract personal tax on shareholders).
• Reveals no information to the market — no signal sent to investors.

#### Debt (Second Choice)

• Cheaper than equity (tax-deductible interest).
• Reveals less information than equity issuance.
• Signals that managers believe the firm's prospects are good (they would not want to dilute equity if they expect high future earnings).

#### Equity (Last Resort)

• Issuing new equity signals to the market that management believes shares are overvalued → stock price typically falls on announcement.
• Involves high transaction costs.
• Dilutes existing shareholders.
• Used only when internal funds are exhausted and debt capacity is reached.

### Key Characteristic

There is no well-defined target debt-equity ratio under this theory — the capital structure at any point is just the cumulative result of following the pecking order.

### Comparison: Pecking Order vs Trade-Off Theory