What is the funding pecking order

Pecking order theory

Pecking Order Theory Definition

The Pecking order theory the financing assumes or determines in practice that there is a "pecking order" / hierarchy of the types of financing: if available, companies prefer to finance themselves from the (operational) cash flow (i.e. through internal financing, profits are retained), This is followed by external financing through outside capital (especially bank loans) and - only at the end - through equity (capital increase).

example

A company is building a new plant for € 100 million. According to the pecking order theory, it would prefer to finance this with e.g. € 60 million from fully retained profits and the remaining € 40 million with a bank loan.

Equity is only raised if it is not enough (e.g. because the bank only grants a loan of € 20 million).

This is justified with the information asymmetry between internal (board members / managing directors) and external (shareholders / shareholders). The former know a lot about the company, its value and the prospects for investment projects, the latter know little about it.

The theory assumes that the company management, in the interests of the owners, issues shares when the shares are highly valued or overvalued (then a lot of money comes in for a few new shares and the existing shareholders are little "diluted"). According to this assumption, the share issue signals to the capital market that the shares may be overvalued (a negative signal).

That is why internal and external financing are preferred.

Conclusion: the pecking order theory explains the financing that can be observed in companies with the information asymmetry between managers and investors. Other reasons are left out, e.g. that debt capital has tax advantages (interest reduces taxable profit) or that it is easier ("without work") to withhold profits (you don't have to negotiate loans or carry out costly capital increases).