Pecking Order Theory
AdvancedPecking order theory is a theory of corporate finance stating that companies prefer to fund investments first with internal cash, then with debt, and only as a last resort by issuing new shares.
The theory, developed by economists Stewart Myers and Nicolas Majluf in 1984, is based on information asymmetry: managers know more about the company's prospects than outside investors do.
Because of this, issuing new shares sends a signal. Investors suspect managers will choose to sell shares when they believe the shares are overvalued, so the share price tends to fall when new shares are announced. Debt is less affected by this problem, and internal cash avoids it entirely. As a result, companies follow a pecking order of financing sources.
For example, a profitable company with plenty of retained earnings may fund new projects internally and carry little debt, not because it has calculated an ideal debt level, but because it simply has not needed outside funding.
The theory helps explain why many highly profitable companies have low debt. It contrasts with the trade-off theory, which suggests companies aim for a target debt level. Evidence supports parts of both theories, and the best explanation varies between types of company.
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