Pecking Order Theory

Overview

Pecking order theory (Myers & Majluf, 1984) argues that firms follow a strict financing hierarchy — internal funds first, then debt, then equity — driven by information asymmetry between managers and outside investors. Unlike tradeoff theory, there is no target leverage ratio.

When to Use

• Explaining why firms accumulate cash rather than return it
• Interpreting market reactions to financing announcements
• Predicting financing choices based on information environment
• Analyzing why high-profit firms often have low leverage

When NOT to Use

• When the firm has minimal information asymmetry (e.g., transparent regulated utilities)
• For firms that actively target a leverage ratio (tradeoff theory better fits)
• When tax considerations clearly dominate financing choices