The pecking order theory suggests that managers prefer to finance investment opportunities by three sources: first through the company’s retained earnings, then Debt and equity are the last resort.
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Pecking Order Theory

Definition

Pecking Order Theory< /b> in English is Pecking Order Theory.

The pecking order theory suggests that managers prefer to finance investment opportunities using three sources: first through the company’s retained earnings, then through debt. and choose equity financing as a last resort.

Content

Theory of pecking order aka theory of capital appreciation starts with asymmetric information – a phrase to indicate that directors know more about the potential, risks and values ​​of their business than outside investors.

– Asymmetric information affects the choice between internal and external financing, and between new issuance of debt and equity securities.

– This will lead to a pecking order whereby investment projects will be financed first with internal capital, mainly profits for reinvestment, and then by issuing new debt and eventually by issuing new equity.

– The pecking order theory explains why firms with low profitability tend to take on more debt.

Not because they have higher target debt ratios but because they need more outside funding. Less profitable firms issue debt because they do not have the internal sources of funds for the capital investment and because debt financing ranks first in a pecking order of external financing.< /p>

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– In pecking order theory, the attractiveness of the tax shield from debt is considered to be the class effect of varying debt ratios in the presence of an asymmetry of internal cash flows, and Real investment opportunity. Profitable businesses with limited investment opportunities will strive for a low debt ratio.

– Firms with greater investment opportunities than internally generated capital. forced to borrow more

Conclusion

– Obviously the pecking order theory is not true for all firms. There are many cases where firms can easily finance through common stock issues.

– But pecking order theory explains why most outside financing is debt and why changes in debt ratios are often followed by external financing needs.

(Reference: Textbook of Corporate Finance, Financial Publishing House; What is the Pecking Order Theory? – CFI)