Pecking Order Theory

Definition of Pecking Order Theory

The theory, named after the behavioural pattern of pecking order among birds, was first identified by Donaldson in 1961 and further developed by Myers and Majluf in 1984.

The Pecking Order Theory: Myers 1984 Interpretation

Building upon Donaldson’s insights, Myers put forward a different perspective to the Pecking Order Theory in 1984, which emphasised more on asymmetry in information. Myers argued that managers who are closest to businesses and are well informed about the true value of the firms might perceive that the market undervalues their firm's equity. Hence, such firms will be more inclined towards debt than equity financing.

Basics of The Pecking Order Theory of Capital Structure

Before going into the fundamental concepts of the Pecking Order Theory, it’s essential to get a grip on what capital structure is.

Under the Pecking Order Theory, the capital structure is dictated by the following hierarchy:

• Internal funds - Retained earnings
• External funds
  • Debt
  • External equity

These preferences are primarily shaped by cost considerations, risk management, and information asymmetry.

Key Assumptions of the Pecking Order Theory

The Pecking Order Theory carries a set of assumptions about firm behaviour. Many of these concern the framing of investment decisions and the way firms structure their financing.

Remember, these assumptions are not universally applicable to every business. Firms may choose to follow different financing paths based on their particular circumstances, market conditions, and business objectives. Therefore, it's important to understand these principles and adapt to the practical situations at hand.

Pecking Order Theory and Corporate Finance

The Pecking Order Theory plays a substantial role in shaping corporate financial decisions. When businesses steer towards expansion or investments, the management often crosses paths with crucial funding decisions. The options to raise money come in varied forms - internal funds, debt, and equity, each with its distinctive advantages and disadvantages. This is where the Pecking Order Theory stakes its claim in guiding these financial decisions, emphasising cost efficiency and minimising risk exposure.

Utilisation of the Pecking Order Theory of Financing

The Pecking Order Theory serves as an operating guide outlining the hierarchy of financial sources that corporations prefer when they need to raise capital. It can be utilised in various circumstances and situations. It can help identify the best financing source based on the company's profile, the nature of the investment, and market scenarios.

In using the Pecking Order Theory, companies can efficiently structure their capital and keep their financial risk within manageable limits. Given the high financial stakes and the need for agility in today's dynamic business environment, the Pecking Order Theory's framework affords companies the ability to make more informed and effective decisions regarding their capital structure.

Practical Examples of the Pecking Order Theory in Finance

In the practical world, businesses frequently resort to the components of the Pecking Order Theory to guide their financial decisions. A key takeaway here is that while the Pecking Order Theory provides an overall guide to companies, they nonetheless adjust their financing preferences based on their specific needs, industry norms, risk tolerance levels, and market conditions. It is also important to note that as a firm grows, debt levels can increase disproportionately. Equity issues can become more frequent as firms evolve and internal capital and debt no longer suffice. Large, well-established firms have different operational and financial structures and, therefore, these companies, in reality, often deviate from the Pecking Order Theory. The theory is more applicable to small and medium enterprises where information asymmetry is pronounced and financial flexibility is crucial for their growth and survival.

Analysing the Pecking Order Theory

In the realm of business finance, the Pecking Order Theory unfolds as a distinctive analytical lens, offering insights into the methodology underlying companies' financial decisions. This financing hierarchy, shaped by risk aversion and information asymmetry, prompts businesses to opt for retained earnings, resorting to debt and equity only when necessary. Positioning this theory under the analytical microscope allows for a clearer comprehension of its applications, benefits, drawbacks, and its tangible footprint in real-world scenarios.

Advantages and Disadvantages of the Pecking Order Theory

The Pecking Order Theory boasts numerous advantages, making it a popular model for corporations. However, like any other financial model, it isn't devoid of limitations. Here's a deep dive into the benefits and drawbacks that come with the Pecking Order Theory:

• Advantages:
  • Encourages Cost Efficiency: The pecking order model encourages efficient use of capital resources by prioritising internal financing via retained corporate earnings - the most economical source of finance compared to debt or equity. This encourages firms to maximise profit retention and minimises the cost of capital.
  • Minimises Information Asymmetry: By primarily resorting to internal finances, businesses can avoid information asymmetry, which typically arises with equity financing when outside investors may lack adequate information about the operational and financial health of the company.
  • Controls Ownership Dilution: By resorting to equity as the final option, this model helps control ownership dilution which is a significant concern for many businesses as issuing more shares can dilute ownership percentages of existing stakeholders.
  • Mitigates Business Risk: As this theory prioritises low-risk sources of finance over high-risk ones, corporations that adhere to this theory are more likely to maintain a manageable level of financial risk.

• Disadvantages:
  • Lacks Flexibility: In a rapidly changing business environment, the rigidity of following a set pecking order might render companies unable to exploit beneficial opportunities that require an alternative financial strategy.
  • Not Universally Viable: The Pecking Order Theory doesn't always hold true, especially for start-ups or small businesses with minimal retained earnings or for those unwilling or unable to take on more debt.
  • Overemphasis on Debt: This model tends to over-emphasise debt over equity, which could lead companies into a debt trap, impinging the financial well-being of the company over the long term.
  • Disregards Potential Benefits of Equity: The theory grows over-reliant on debt at the expense of equity, possibly overlooking the benefits that equity capital can bring such as not needing to be repaid and the lack of attached interest repayments.

Real-Life Examples of the Pecking Order Theory

Keep in mind, every business is unique, and different enterprises might have different financial practices. While the Pecking Order Theory provides a useful guideline, it may not be necessarily followed by all firms at all times. Other factors such as cash flow conditions, management's risk appetite and market conditions might influence the financing decisions of the firm.