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Pecking Order Theory of Capital Structure

What is Pecking Order Theory

Pecking order theory is one of several theories related to the capital structure

Capital structure is a comparison between capital vs debt.

Pecking order theory was discovered by Donaldson in 1984 which was later refined by Myers and Majluf. Pecking order theory states that companies tend to seek funds that have a low risk. The risk of declining corporate value. The fall in stock prices.

The pecking order theory prefers funding from internal funds source rather than external source. There is no optimal capital structure in the pecking order theory because the selection of corporate funding is based on the order of risk preference (hierarchy). Sort order of funding.

The company's funding can be obtained from at least 3 sources.
  1. Retained earning
  2. Debt
  3. Equity (issuance of new stocks)
PECKING ORDER THEORY
Hierarchy of pecking order theory

First, the company will prioritize risk-free financing, and then the company chooses low-risk funds, and the last alternative option is to choose funds that has a higher risk

Retained earnings are the first option choosed by a company to meet their funding because it's no risk or the risk not as high other funding. Retained earnings is internal funding generated by the operational activities in the previous period.

Retained earnings is cheaper and dosn't need to disclose any amount of company information (which must be disclosed in the prospectus when issuing new bonds and shares).

If the retained earnings can't meet the company's funding needs, management will choose external financing options.

External financing consist of debt and equity financing.

Pecking order theory prioritizes taking out debt financing first rather than equity financing. The risk debt is less than the funding risk of equity.

If debt can't be earned, the last option is to get funding from equity or issuance of new stock. Shareholders judge that issuing new shares is riskier than debt.

How the Pecking Order Theory Work

The pecking order theory arise because of the asymmetry of information on the company. Asymmetry of information is an imbalance of information held by the management (internal) and shareholders or creditors (external).

In general, managers have more information about the performance, prospects and risks the company rather than the shareholders or creditors have. Even in some cases there are companies that have very high levels of information asymmetry.

However it is too difficult for a shareholder to know in detail every information about the company. Thus, the information asymmetry will always exist in every company. It can not be avoided.

The ever increasing asymmetry of information could lead to increasing risk. High risk causes expected return higher.

High risk, high return.

If investors or creditors have little information about the company, they would expect to get a high profit on the risks taken.

In addition to having to provide high returns, the company must also spend money to get external financing such as interest, agency cost, emission fees and other accompanying costs.

That is the reason why companies prefer funding that comes from internal sources, retained earnings. Because it is easy, cheap and has a low risk.

If the company has no retained earnings or retained earnings are not sufficient, the company will seek funds from outside the company.

There are two option. Taking on debt or issuance of new shares

Management prefers to take funding from debt rather than adding new shares. this decision is based on the cost of debt that is lower than the cost of equity of new shares issuance.

Of course, the addition of debt will increase the proportion of debt in the capital structure of the company. And interest on debt will be a "shield" of taxes in the future.

On the other hand, excessive debt accretion on the company's capital structure has the risk of default. It's very risky for the company.

Then the issuance of new stocks is the last option that can be taken if the proportion of corporate debt is in a position that can not be added anymore.

The pecking order theory does not prohibit a company from adding new shares. It's just not recommended to be the main source of funding, but as a last resort if other options are unreliable.

Signals From The Decision of Pecking Order Theory

The company's funding decision will always get a response from the market. Both positive and negative responses.

Whatever is chosen is the signal shown to the investors. There will always be a reaction in every decision.

# Retained earning

If the company is able to meet its own funding needs from retained earnings, it does not require external funding. So the market will respond and give a positive signal indicating that the company has a good performance, which can afford its own needs from the reserves.

# Debt

If the company decides to take the debt. The market will respond that the company's management has the ability to pay its obligations on a regular basis.

#Equity

If the company issues new shares, this is a negative signal.

In addition to pointing out that the company is unable to generate retained earnings and shows the inability of management to repay debt, issuance of new shares is a sign or signal to shareholders and prospective investors about the current state of the company and the upcoming prospects are not good.

All This is inseparable from the information asymmetry.

Issuance of new shares is not preferred by shareholders. The percentage of share ownership will decrease due to additional new shares (delusional effect)

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