What is the Pecking Order Theory?
Pecking order theory refers to the theory with respect to the capital structure of the company where the managers are required to follow a specified hierarchy while making the choice of the sources of finance in the company where according to the hierarchy first preference is given to the internal financing, then to external sources when enough funds cannot be raised through internal financing where debt issue will be considered first to generate funds and lastly the equity if the funds cannot be raised through the debt as well.
This theory was first suggested by Donaldson in 1961 and later made modified by Myers and Majluf in 1984. This theory might not always be the optimum way, but it does provide guidance on 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.
#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. 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). of losses still stays with the company.
If the company is taking up a risky project but their risk preferences are low, then internal financing is not the optimum way to finance the project. The second reason is taxation. By taking debt, the company can reduce their taxes based on the amount of interest they are paying on the debt. Internal Financing has more stringent regulations on how the funds can be invested without tax. Above all, to finance the project budget internally, the company has to have enough funds – which limits the other ways that capital can be utilized.
#2 – External Funding
External financingExternal FinancingAn external source of finance is the one where the finance comes from outside the organization and is generally bifurcated into different categories where first is long-term, being shares, debentures, grants, bank loans; second is short term, being leasing, hire purchase; and the short-term, including bank overdraft, debt factoring. can be of two types. By taking the requisite budget as a loan or by selling a part of the company’s share as equity. There is an entire discussion on how to choose an optimum capital structure that can help the company in minimizing the cost of capital and maximizing the risk transfer. However, that discussion is out of scope for this article and that shall be dealt with in another article separately. Now, let us dwell on details about each type of 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 own interest rates and price 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. accordingly.
The company will also have the flexibility to buy back the bonds if it wants to or create a bond structure that supports the company’s operational structure. However, bonds are not really an ideal way, if the company wants to make sure of the funding. Many things could go against the company while raising money from bonds. However, even though a bit expensive and the company has to pledge assets, raising money through bank loans gives the company a guarantee 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. 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 raises around the information asymmetry – where one party, the company holds better information than the other (in case of external financing). To compensate for the information asymmetry and risk transfer, external financing is generally more expensive than internal financing. Equity holders, who hold the highest risk, in general, demand more returns than debt holders do – though the company has no obligation to hold true to that 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..
- The company has net earnings, cash and other equivalents of 210 million USD on 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.
- The bank agreed to lend the company money at a rate of 8.5% because of the debt rating of the company
- The company can raise equity, but at a discount of 7.5% i.e., if the company issues further rounds of funding, the share price of the company would fall down by 7.5% and that is the rate at which the company can raise the funding.
If the company has to raise funds for the project, it can do by either one or a combination of 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. 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 put back the company’s 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. in using debt financing. The interest will be tax-deductible, so the 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. will be less than that of the actual interest being 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 make a decision on 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. This makes it difficult to see where 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. holds in the pecking order theory. It is a sort of private equity but also 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.. This is a classic scenario where POT holds true and the company followed a specific hierarchy to raise money for expansion.
Where POT fails: However before the company raised first debt round in 2016 and after the first internal financing round in 2016, it had over 6 rounds of financing where it raised about 2 billion USD through selling equity – privately. Pecking order theory is based on information asymmetry and such cases are not covered in it. This is a limitation of the pecking order theory.
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 be used to change the cost of financing.
Disadvantages: Where 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..
- 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 be useful in making practical applications because of theoretical nature.
- Limits the types of funding.
- New types of funding cannot be included in the theory.
- The very old theory that has not been updated with newer financial methods of fundraising.
- No Risk vs Reward measure to include in the cost of financing.
Important Points of Pecking Order Theory
Pecking Order Theory helps only in analyzing a decision but not in actually making it. It does not help in calculating the costs and looking at Uber’s example it will explain that in reality, companies do not actually follow in the same order.
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 how to select financing rounds but there are a lot of other metrics. Using POT in a mixture of other metrics will provide a useful way to make a decision about financing.
This has been a guide to what is 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 –