Pecking Order Theory

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The Pecking Order Theory was developed by Stewart C. Myers in 1984. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means “of last resort”. Hence internal funds are used first, and when that is depleted debt is issued, and when it is not sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required.

[edit] Evidence

Tests of the Pecking Order Theory have not been able to show that it is of first order importance in determining firm's capital structures, however several authors have also been able to find there are instances where it is a good approximation to reality. On the one hand Fama and French ^[1],, and also Myers and Shyam-Sunder ^[2]find that some features of the data are better explained by the Pecking Order than by the Trade-Off Theory. Goyal and Frank for example show, among other things, that the Pecking Order theory fails where it should hold, that is, for small firms where information asymmetry is presumably an important problem. ^[3]

[edit] See Also

Corporate Finance

Trade-Off Theory

Capital Structure

Market timing hypothesis

[edit] References

1. ^ "Testing Trade-Off and Pecking Order Predictions About Dividends and Debt", Review of Financial Studies 2002. http://rfs.oxfordjournals.org/cgi/content/abstract/15/1/1
2. ^ "Testing static trade-off against pecking order models of capital structure", Journal of financial Economics 1999.http://www.fin.ntu.edu.tw/~kchan/Handouts/Shyam-Myers_1999.pdf
3. ^ "Testing the pecking order theory of capital structure", Journal of Financial Economics,2003 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=243138