The pecking order theory is a capital structure theory that states that the choice of equity or debt by companies depends upon the existence of asymmetric information. The theory was first introduced by Donaldson in 1961, which was later amended in 1984 by Myers and Majluf. There are three sources of finance available to companies, which include internal equity in the form of retained earnings, external debt, and new equity that could be acquired from issuing new shares in the capital market.
The theory states that companies prefer these sources of funds in the order of using internal equity first, then debt, and lastly, new equity. The choice of finance signals the current business position and financial performance of a company. If the company uses its internal funds, then the decision signals that it has significant retained earnings or the ability to generate a high profit. The decision will attract investors, and the stock price will increase. The theory indicates that companies do not prefer to raise new equity when there is asymmetric information.
Managers have more information and knowledge of the company’s prospects than investors, which creates information asymmetry. A company prefers debt to equity because it signals positively that it can generate a high profit and pay periodic interest obligations. Moreover, the theory explains that investors may view the decision made by managers to raise new equity as a way of taking advantage of stock overvaluation. Therefore, in this case, investors may not be willing to pay the current value of stocks and place a lower value. It would cause the stock price to fall, which is not beneficial for the company.