Pecking Order Theory Case Study

When introducing the pecking order theory, Myers (1984) already acknowledged that the pecking order theory would not be able to explain all debt and equity choices of firms. However, he noted that, in the aggregate, the pecking order theory is able to explain the observed reliance of companies on internal financing and leverage.

The pecking order theory of capital structure is derived from the point of informational asymmetry between firms’ managers and investors (Myers & Maljuf, 1984). It is assumed that since managers are insiders in a firm, they have access to better information than investors. Furthermore, Majluf and Myers (1984) assume that managers aim to maximize the value of shares of existing shareholders, and that investors know

Selling overvalued shares transfers value from new investors to existing shareholders. Whereas selling undervalued shares has the opposite effect. New investors will discount the possibility of buying overvalued shares, and only be willing to buy the new shares at a lower price. Empirically it is found that announcements of stock issues are accompanied with negative returns of around three percent on average, and increasing in the size of the issue and the extent of information asymmetry (Myers, 2001). This drop in price is much greater than underwriting or transaction costs. Therefore, managers would only be willing to issue undervalued equity for a growth opportunity if the NPV of the investment project is larger than the negative effect of the equity issue for existing shareholders. As a result, for firms with undervalued shares the rational decision can be not to issue equity, even as that leads to the rejection of a positive NPV investment (Myers & Maljuf,

Therefore, under the pecking order theory, it is predicted that firms will prefer to use internal funds first. This serves to maximize the value of existing shareholders’ shares. Only when internal funds are exhausted and positive NPV projects are still available will managers seek external sources of financing (Myers & Maljuf, 1984). And managers will maximize value by issuing debt before issuing equity.

These two conclusions of the pecking order theory of capital structure are summarized below:

(1) Firms prefer internal financing to external financing

(2) Firms issue debt before equity when external financing is needed.

In addition, under the pecking order theory, firms do not have a target debt-to-equity ratio (Myers, 2001). At any point in time, the extent of leverage and the debt-to-equity ratio in a firm are the result of historical requirements for external financing. The theory also gives an explanation for why more profitable firms are relatively inactive on debt markets (Myers, 2001). That is, more profitable firms can rely on internal cash flows to finance their investments, whereas less profitable firms have insufficient internally generated funds available and therefore increase their