The Pecking Order Theory in Finance

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The pecking order theory is an explanation of a firm’s debt-to-equity financing portfolio. It helps investors to understand how a company sources its financing. In other words, the pecking order theory shows the optimal debt and equity structure of a firm’s financing model.

  • Pecking order theory is essentially an idea that helps the managers of a company to decide how to finance the company.

  • It is based on a hierarchy where the managers first use retained earnings (internal financing), then debt financing, and then equity financing.

Internal Financing

Usually, the managers of a firm tend to use internal financing as the first choice because there are no strings attached to it. The managers may choose retained earnings preferentially because it does not come with any repayment or payback attachment. The managers may use it whichever way they decide it is suitable, and there is no cost of equity or debt that has to be accounted for.

Debt Financing

The second choice the managers have for sourcing the funds is debt financing.

  • Whether to take debt and how much of it is sufficient usually depend upon the interest that the company has to pay for the finance they have sourced.

  • Debt financing is a costlier option than retained earnings because, in the case of the latter, no interest has to be paid.

Equity Financing

Equity financing is the last option for sourcing the funds for the companies. It is the costliest form of financing because the cost of equity — the shares and securities — is the highest.

The Effect of Asymmetric Information on Pecking Order Theory

Asymmetric information plays a major role in the pecking order theory. According to it, the more asymmetric the information, the riskier are the investments.

  • In the case of retained earnings, the amount of asymmetric information is the lowest. That is, there is no lack of information within the firm about itself, so the asymmetric information is the lowest or symmetric information is the highest.

  • In the case of debt financing, asymmetric information is more than retained earnings. The investors do not know everything about the company they are investing in, but still, they can be sure that there will be a repayment. So, the amount of asymmetric financing is mediocre in the case of debt financing.

  • The amount of asymmetric financing is the highest in the case of equity financing because investors do not know mostly anything about the company. That is why, the cost of equity financing, as well as the risks, are the highest in the case of equity financing. However, since the risks are higher than debt financing in the case of equity financing, the returns are also more than debt financing in case the company posts a profit.

Updated on 03-Dec-2021 10:30:53