What is the Pecking Order Theory?

Donaldson first suggested this theory in 1961 and later modified it by Myers and Majluf in 1984. This theory might not always be the optimum way, but it does guide how to start financing.

Components of Pecking Order Theory of Capital Structure

Broadly, the method of raising funds for a project or a company is classified into internal and external funding.

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#1 – Internal Funding

Internal funding/ financing comes from retained earnings a companyRetained Earnings A CompanyRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more has. Why do the CFOs prefer internal funding? Because it is easier to raise funding, the initial funding setup costs are almost zero – because no bankers are involved. Even though internal financing is pretty easy and simple, there are reasons why it might not be preferred. One is that the risk transferRisk TransferRisk transfer is a risk-management mechanism that involves the transfer of future risks from one person to another. One of the most common examples of risk management is the purchase of insurance, which transfers an individual’s or a company’s risk to a third party (insurance company).read more of losses still stays with the company.

#2 – External Funding

#3 – Debt

As the name says, debt funding is where the company raises the required amount through a loan – either by selling bonds if the company wants to raise loans in a tradeable market or by pledging assets if the company wants to raise loans through the banking system. Each of these ways has its own merits and demerits on how to raise a loan. Raising through markets will give the company to choose their interest rates and The bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read moreprice their bondsPrice Their BondsThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more accordingly.

The company will also have the flexibility to buy back the bonds if it wants to or create a bond structure that supports its operational structure. However, bonds are not ideal if the company wants to ensure the funding. Many things could go against the company while raising money from bonds. However, even though it is a bit expensive and the company has to pledge assets, raising money through bank loans guarantees that the money will be raised.

#4 – Equity

No chief of a company would want to sell a part of their company unless deemed necessary. However, there are cases where the only way to raise money is by selling the company. Be it a failure of the company to raise money through debt, or be it the inability of a company to maintain enough portfolio to raise money through bank loans, the company can always sell a part of itself to raise money.

One great advantage of equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more is that it is not risky. It is completely dependent on the buyer to own a share of the company, and the risk transfer is a hundred percent in this case. The company has no obligation to pay the shareholder anything.

POT says that the order in which the company tries to raise funding is:

Internal Financing -> Debt -> Equity.

The basic nature of POT arises around the information asymmetry – where one party, the company, holds better information than the other (in case of external financing). External financing is generally more expensive than internal financing to compensate for the information asymmetry and risk transfer. In general, equity holders, who hold the highest risk, demand more returns than debt holders, though the company has no obligation to hold those returns.

Pecking Order Theory Examples

The following are examples of the pecking order theory

#1. Basic Example of Pecking Order Theory of Capital Structure

Consider the following situation. A company has to raise 100 million USD to expand their product to different countries. In addition, the following is the financial structure of the companyThe Financial Structure Of The CompanyThe financial structure refers to the sources of capital and the proportion of financing that comes from short term liabilities, short term debt, long term debt, and equity to fund the company’s long term and short term working capital requirements.read more.

  • The company has net earnings, cash, and other equity of 210 million USD onA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more their balance sheetsTheir Balance SheetsA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read moreThe bank agreed to lend the company money at a rate of 8.5% because of the company’s debt rating.The company can raise equity, but at a discount of 7.5%, i.e., if the company issues further rounds of funding, the company’s share price would fall by 7.5%, which is the rate at which the company can raise the funding.

If the company has to raise funds for the project, it can combine the above methods. The pecking order theory says that the cost of funding will be in ascending order in the above case. Let us calculate it for ourselves and try to verify the same.

  • Case 1: If the company uses its cash and other equivalents to fund the project, the cost of financing would be 100 million USD. There will not be any additional costs, except for the opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It’s essentially the cost of the next best alternative that has been forgiven.read more of money. Valuing opportunity cost is a different subject in its entirety.Case 2: If the company uses debt to raise its funds, it will return its profit by 8.5 million dollars – which will be paid as interest. However, the company will have tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more in using debt financing. The interest will be tax-deductible so that theEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period.read more effective interest rateEffective Interest RateEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period.read more will be less than the actual interest paid. Therefore, the total one-year cost would be less than 108.5 million USD, but greater than 100 million USD.Case 3: If the company raises funds through equity, it will cost the company 108.12 million USD (100 million divided by 92.5% – 7.5% discount on raising additional equity)

Now, depending on the risk preference of the company, the CFO can decide how to raise the capital accordingly.

#2. Real-Life Practical Example of Pecking Order Theory (Uber)

To see if, and how, the Pecking Order Theory holds in real life, let us consider a couple of companies and how they raised financing. Since these are real companies, the order in which they raised the funding will have a lot of other variables that take a role in decision-making. For example, when the theory was developed, the concept of venture capital was at a very nascent stage. It isn’t easy to see whereVenture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. read more venture capitalVenture CapitalVenture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. read more holds in the pecking order theory. It is a sort of private equity and has similarities to internal financing as nothing is pledged. It also has characteristics towards equity – since the venture capitalists expect more than the general equity – because they hold the risk.

The following image shows how Uber’s funding rounds have gone through. Let us only use a couple of examples to prove POT and a couple to disprove POT.

Where POT holds: The first round of funding, as expected, is raised by the founders of Uber – Letter one Holdings SA. They used 200,000 USD of their own money in 2016, without any obligations. The first debt round for Uber came around in 2016, where it raised 1.2 billion USD, a post that Uber had another debt round where it raised 2 billion USD. Most recently, Uber raised about 500 million USD via an Initial Public OfferingInitial Public OfferingAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more. It is a classic scenario where POT holds, and the company follows a specific hierarchy to raise money for expansion.

Where POT fails: However, before the company raised its first debt round in 2016 and after the first internal financing round in 2016, it had over six financing rounds. It raised about 2 billion USD through selling equity – privately. This is a limitation of the pecking order theory. Pecking order theory is based on information asymmetry, and such cases are not covered.

Advantages: Where POT is useful?

  • POT is valid and useful guidance to verify how information asymmetry affects the cost of financing.It provides valuable direction on how to raise funding for a new project.It can explain how information can change the cost of financing.

Disadvantages: Where does POT fails?

  • The theory is very limited in determining the number of variables that affect the cost of financingCost Of FinancingFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains.read more.It does not provide any quantitative measure of how information flow affects the cost of financing.

Limitations of Pecking Order Theory

  • Limited to a theory.Pecking order theory cannot make practical applications because of its theoretical nature.Limits the types of funding.New types of funding cannot be included in the theory.The very old theory has not been updated with newer financial fundraising methods.No-Risk vs. Reward measure to include in the cost of financing.

Important Points of Pecking Order Theory

Pecking Order Theory helps only analyze a decision but not in actually making it. It does not help in calculating the costs and looking at Uber’s example, and it will explain that, in reality, companies do not follow in the same order.

Conclusion

POT describes what and how financing should be raised without providing a quantitative metric to measure how it has to be done. POT can be used as a guide in selecting financing rounds, but there are a lot of other metrics. Using POT in a mixture of other metrics will provide a useful way to finance.

This has been a guide to Pecking Order Theory and its definition. Here we discuss the components of the Pecking Order Theory in capital structure along with examples, advantages, disadvantages, and limitations. You can learn more about financing from the following articles –

  • Dollar Cost AveragingShort Term FinancingAsset FinancingCost of Refinancing