Basic Pecking Order Theory

Introduction

Background of the Study

Capital structure is one of the finance topics among the studies of researchers and scholars. Its importance derives from the fact that capital structure is tightly related to the ability of firms to fulfil the needs of various stakeholders. Capital structure represents the major claim to a corporation’s assets. This includes the different types of both equities and liabilities (Riahi-Belkaonui, 1999). Capital structure is the combination of debt and equity that make the total capital of firms. The proportion of debt to equity is a strategic choice of corporate managers. Capital structure decision is the vital one since the profitability of an enterprise is directly affected by such decision. Hence, proper

According to Myers, (1984) firms prefer to finance new investments, first internally with retained earnings, then debt, and finally with the issue of new equity. Myers (1984) argues that an optimum capital structure is difficult to define as equity appears at the top and bottom of the “pecking order”. According to Myers (1984) internal funds incur no floatation costs thus firms will prefer to use them to finance their investments since they have no conditions attached to it unlike debt.

The pecking order theory is about what the firm‟s management will prefer in terms of the sources of finance to use. Firstly firms will chose internal finance that is using profits from previous years. Secondly if there is insufficient internally generated funds, firms will chose to lend money from credit institutions such as banks and thirdly as a last resort, firms will issue additional shares. In a nut shell the pecking order theory states that a firm‟s management favors internal financing to external financing.

2.3. Empirical literature

This section examines the empirical studies conducted by various researchers relevant to this study. The literature is organized in tandem with the study

This is due to the importance of working capital to manufacturing firms which range from the purchase of raw materials, payment of accounts payable and finally credit management. Thus firms with high gearing ratios are usually forced to issue equity as a mechanism of counteracting the effect of debt on the operating cash flow in order to positively enhance their working capital which according to Nyabwanga, (2011) is the lifeline of a firm. This notion upholds the underlying principle of the pecking order theory as opined by Myers, (1984) since equity appears both at the beginning and the end of the capital structure of an