Pecking order theory

In corporate finance, the pecking order theory (or pecking order model) postulates that the cost of financing increases with asymmetric information.

Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a “last resort”. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant ‘bringing external ownership’ into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance.

The pecking order theory is popularized by Myers and Majluf (1984)[1] where they argue that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance.


.. Pecking order theory starts with asymmetric information as managers know more about their company’s prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. Therefore, there exists a pecking order for the financing of new projects.

Asymmetric information favours the issue of debt over equity as the issue of debt signals the board’s confidence that an investment is profitable and that the current stock price is undervalued (were stock price over-valued, the issue of equity would be favoured). The issue of equity would signal a lack of confidence in the board and that they feel the share price is over-valued. An issue of equity would therefore lead to a drop in share price.


.. The pecking order theory explains the inverse relationship between profitability and debt ratios:

  1. Firms prefer internal financing.
  2. They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends.
  3. Sticky dividend policies, plus unpredictable fluctuations in profits and investment opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the firm pays off the debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities, rather than reduce dividends.
  4. If external financing is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In addition, issue costs are least for internal funds, low for debt and highest for equity. There is also the negative signaling to the stock market associated with issuing equity, positive signaling associated with debt.[8]


Capital structure substitution theory

The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (EPS) are maximized. Managements have an incentive to do so because shareholders and analysts value EPS growth.

.. The capital structure substitution theory has the potential to close these gaps. It predicts a negative relation between leverage and valuation (=reverse of earnings yield) which in turn can be linked to profitability. But it also predicts that high valued small growth firms will avoid the use of debt as especially for these companies the cost of borrowing ({\displaystyle R_{\text{x,t}}}) is higher than for large companies, which in turn has a negative effect on their EPS. This is consistent with the finding that “…firms with higher current stock prices (relative to their past stock prices, book values or earnings) are more likely to issue equity rather than debt and repurchase debt rather than equity”.[4]

.. In times when the market is under-priced, corporate buyback programs will allow companies to drive up earnings-per-share, and generate extra demand in the stock market. In times when the index was under-priced relative to the model equilibrium, repurchase programs will be stopped and demand is reduced.

Why Capital Structure Matters

Companies that repurchased stock two years ago are in a world of hurt.

Thirty-five years ago business publications were writing that major money-center banks would fail, and quoted investors who said, “I’ll never own a stock again!” Meanwhile, some state and local governments as well as utilities seemed on the brink of collapse. Corporate debt often sold for pennies on the dollar while profitable, growing companies were starved for capital.


If that all sounds familiar today, it’s worth remembering that 1974 was also a turning point. With financial institutions weakened by the recession, public and private markets began displacing banks as the source of most corporate financing. Bonds rallied strongly in 1975-76, providing underpinning for the stock market, which rose 75%. Some high-yield funds achieved unleveraged, two-year rates of return approaching 100%.

The accessibility of capital markets has grown continuously since 1974. Businesses are not as dependent on banks, which now own less than a third of the loans they originate. In the first quarter of 2009, many corporations took advantage of low absolute levels of interest rates to raise $840 billion in the global bond market. That’s 100% more than in the first quarter of 2008, and is a typical increase at this stage of a market cycle. Just as in the 1974 recession, investment-grade companies have started to reliquify. Once that happens, the market begins to open for lower-rated bonds. Thus BB- and B-rated corporations are now raising capital through new issues of equity, debt and convertibles.

This cyclical process today appears to be where it was in early 1975, when balance sheets began to improve and corporations with strong capital structures started acquiring others. In a single recent week, Roche raised more than $40 billion in the public markets to help finance its merger with Genentech. Other companies such as Altria, HCA, Staples and Dole Foods, have used bond proceeds to pay off short-term bank debt, strengthening their balance sheets and helping restore bank liquidity. These new corporate bond issues have provided investors with positive returns this year even as other asset groups declined.

The late Nobel laureate Merton Miller and I, although good friends, long debated whether this kind of capital-structure management is an essential job of corporate leaders. Miller believed that capital structure was not important in valuing a company’s securities or the risk of investing in them.

My belief — first stated 40 years ago in a graduate thesis and later confirmed by experience — is that capital structure significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors

  1. the company and its management,
  2. industry dynamics, t
  3. he state of capital markets,
  4. the economy,
  5. government regulation and social trends.

When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies.

Over the past four decades, many companies have struggled with the wrong capital structures. During cycles of credit expansion, companies have often failed to build enough liquidity to survive the inevitable contractions. Especially vulnerable are enterprises with unpredictable revenue streams that end up with too much debt during business slowdowns. It happened 40 years ago, it happened 20 years ago, and it’s happening again.

Overleveraging in many industries — especially airlines, aerospace and technologystarted in the late 1960s. As the perceived risk of investing in such businesses grew in the 1970s, the price at which their debt securities traded fell sharply. But by using the capital markets to deleverage — by paying off these securities at lower, discounted prices through tax-free exchanges of equity for debt, debt for debt, assets for debt and cash for debt — most companies avoided default and saved jobs. (Congress later imposed a tax on the difference between the tax basis of the debt and the discounted price at which it was retired.)

Issuing new equity can of course depress a stock’s value in two ways:

  1. It increases the supply, thus lowering the price; and it
  2. “signals” that management thinks the stock price is high relative to its true value.

Conversely, a company that repurchases some of its own stock signals an undervalued stock. Buying stock back, the theory goes, will reduce the supply and increase the price. Dozens of finance students have earned Ph.D.s by describing such signaling dynamics. But history has shown that both theories about lowering and raising stock prices are wrong with regard to deleveraging by companies that are seen as credit risks.

Two recent examples are Alcoa and Johnson Controls each of which saw its stock price increase sharply after a new equity issue last month. This has happened repeatedly over the past 40 years. When a company uses the proceeds from issuance of stock or an equity-linked security to deleverage by paying off debt, the perception of credit risk declines, and the stock price generally rises.

The decision to increase or decrease leverage depends on market conditions and investors’ receptivity to debt. The period from the late-1970s to the mid-1980s generally favored debt financing. Then, in the late ’80s, equity market values rose above the replacement costs of such balance-sheet assets as plants and equipment for the first time in 15 years. It was a signal to deleverage.

In this decade, many companies, financial institutions and governments again started to overleverage, a concern we noted in several Milken Institute forums. Along with others, including the U.S. Chamber of Commerce, we also pointed out that when companies reduce fixed obligations through asset exchanges, any tax on the discount ultimately costs jobs. Congress responded in the recent stimulus bill by deferring the tax for five years and spreading the liability over an additional five years. As a result, companies have already moved to repurchase or exchange more than $100 billion in debt to strengthen their balance sheets. That has helped save jobs.

The new law is also helpful for companies that made the mistake of buying back their stock with new debt or cash in the years before the market’s recent fall. These purchases peaked at more than $700 billion in 2007 near the market top — and in many cases, the value of the repurchased stock has dropped by more than half and has led to ratings downgrades. Particularly hard hit were some of the world’s largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial, Lincoln National, Washington Mutual); retailers (Macy’s, Home Depot); media companies (CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox).

Without stock buybacks, many such companies would have little debt and would have greater flexibility during this period of increased credit constraints. In other words, their current financial problems are self-imposed. Instead of entering the recession with adequate liquidity and less debt with long maturities, they had the wrong capital structure for the time.

The current recession started in real estate, just as in 1974. Back then, many real-estate investment trusts lost as much as 90% of their value in less than a year because they were too highly leveraged and too dependent on commercial paper at a time when interest rates were doubling. This time around it was a combination of excessive leverage in real-estate-related financial instruments, a serious lowering of underwriting standards, and ratings that bore little relationship to reality. The experience of both periods highlights two fallacies that seem to recur in 20-year cycles: that any loan to real estate is a good loan, and that property values always rise. Fact: Over the past 120 years, home prices have declined about 40% of the time.

History isn’t a sine wave of endlessly repeated patterns. It’s more like a helix that brings similar events around in a different orbit. But what we see today does echo the 1970s, as companies use the capital markets to push out debt maturities and pay off loans. That gives them breathing room and provides hope that history will repeat itself in a strong economic recovery.

It doesn’t matter whether a company is big or small. Capital structure matters. It always has and always will.