The Pecking Order Theory Review

Myres (1984) worked on pecking order theory and suggested that management follows a preference ordering when it comes to financing. First internal financing of investment opportunities is preferred, in part because it avoids the outside scrutiny of suppliers of capital.  Also, there is no flotation costs associated with the use of retained earnings. A target dividend payout ratio is set in keeping with long run investment opportunities.

Management wishes to avoid sudden changes in dividend. When cash flows are insufficient to fund all desirable investment opportunities, and that sticky dividend policy precludes a dividend cut, resort must be made to external financing. Second debt is preferred. Not only does debt result in less intrusion into management by suppliers of capital, but flotation costs are less than with other types of external financing. Also, asymmetric information and financial signaling considerations come into play.

Debt issues are regarded as good news by investors. The reason is the belief that management will never issue an undervalued security. If debt is issued, this means management believes that the stock is undervalued and the debt either overvalued or valued fairly by the market. Third least desirable security to issue is equity. Not only are investors the most intrusive, but flotation costs are higher than with the other methods of financing and there is likely to be an adverse signaling effect. According to the pecking order hypothesis, equity is issued only as a last resort.

The pecking order story is mainly a behavioral explanation of why certain companies finance the way they do. It is consistent with some rational arguments, such as asymmetric information and signaling, as well as with flotation costs. Moreover, it is consistent with the observation that most profitable companies within an industry tend to have the least amount of leverage. However, the pecking order hypothesis suggests that corporations do not have a well thought out capital structure. Rather, a company finances over time with the method providing the least resistance to management, and there is little in the way of capital market discipline on management’s behavior.

Fama & French (2002) argued that balancing costs in the pecking order may force many firms with persistently large investments to have high leverage. This seems less likely for dividend payers since they have a source of retained earnings that can help maintain less leverage. Moreover dividend payers tend to be firm with high earnings relative to investment. Thus for dividend payers, the prediction that firms with larger expected investment have less current leverage may be on solid ground.

They also found those firms that do not pay dividends typically have large investments relative to earnings. Thus for non-payers the negative relation between leverage and expected investment predicted by the complex pecking order is more tenuous, and the positive relation between leverage and investment  of the simple pecking order may dominate.

Fama & French (2002) discussed that in the complex pecking order model, firms balance current and expected financing cost, and firms with larger expected investments are pushed toward keeping low risk debt capacity to finance future investment. The likely result is a negative relation between leverage and expected investment. Whether this prediction applies to book or market leverage depends on whether low risk debt capacity is a function of the book or the market value of assets, an issue on which there is ambiguity.

           

When larger expected investments lead to less book leverage, they also produce less market leverage if the investments are expected to be profitable and so add to current market value. But when low risk debt capacity depends on market value, the relation between market leverage and expected investment is negative, and there is no prediction about book leverage. Whether the predicted negative relation between leverage and the dividend payout ratio applies to book or market leverage also depends on whether low risk debt capacity is a function of the book or market value of assets.

The pecking order theory explains why the bulk of external financing comes from debt. It also explains why more profitable firms borrow less not because their target debt ratio is low, Myres (1984) argued that in the pecking order they don’t have a target debt but because profitable firms have more internal financing available, less profitable firms require external financing, and consequently accumulate debt.