The Pecking Order Theory

The pecking order theory (Myers and Majluf (1984) and Myers (1984)) and its extensions (Lucas and McDonald (1990)) are based on the idea of asymmetric information between managers and investors. Managers know more about the true value of the firm and the firm's riskiness than less informed outside investors. To avoid the underinvestment problem, managers will seek to finance the new project using a security that is not undervalued by the market, such as internal funds or riskless debt. Therefore, this affects the choice between internal and external financing. The pecking order theory is able to explain why firms tend to depend on internal sources of funds and prefer debt to equity if external financing is required. Thus, a firm's leverage is not driven by the trade-off theory, but it is simply the cumulative results of the firm's attempts to mitigate information asymmetry.

The trade-off models have dominated the capital structure literature. The tax benefit-bankruptcy cost trade-off models (DeAngelo and Masulis (1980)) predict that firms will seek to maintain an optimal capital structure by balancing the benefits and the costs of debt. The benefits include the tax shield whereas the costs include expected financial distress costs. Under the agency theoretical models (Jensen and Meckling (1976), Myers (1977) and Jensen (1986)) firms use the benefits of reducing potential free cash flow problems and other potential conflicts between managers and shareholders, to offset costs associated with underinvestment and asset substitution problems. These theories predict that firms maintain an optimum capital structure where the marginal benefit of debt equals the marginal cost. The implication of these trade-off models is that firms have target leverage and they adjust their leverage toward the target over time.

The theory is an important one while studying the Financial Economics concepts. The theory describes that the companies