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the newly offered shares. Outside investors, however, are less skeptical when a firm issues new debt
securities, because debt holders have a contractual and priority claim on the cash flows of the firm.
Debt finance and debt securities are safer to investors, and equity finance and shares of stock are
riskier to investors. Investors, therefore, reduce the price they are willing to pay for newly issued
shares relatively more, and they reduce the price they are willing to pay for new debt securities
relatively less.
This logic is the basis of the pecking order theory of capital structure, which results in the following
three-part pecking order when financing the firm:
1. Financial managers prefer to use internal financing first, because outside investors cannot
undervalue your newly issued stock and bonds if you do not issue these securities.
2. If the firm‟s internal financing sources are exhausted, financial managers prefer to issue
safer securities, as they are less likely to be undervalued by outside investors. That means
financial managers will use debt finance and issue new debt securities next.
3. Financial managers will use equity finance and issue new shares of stock only when the
firm‟s internal financing sources and debt capacity have been exhausted. Equity finance is the
riskiest and most likely to be undervalued by outside investors, so financial managers will sell
new shares of stock only when there is no other alternative.
Simply put, the pecking order theory tells us that financial managers finance the firm with internal
sources, then issue safer debt securities, and, as a last resort, issue riskier equity securities.
The implications of the pecking order theory differ significantly from the trade-off theory of capital
structure. The first implication is that there is no optimal or target capital structure. Each firm‟s capital
structure is determined by its need to fund internal investments, and its internal sources of funds and
debt capacity. Financial managers do not attempt to maintain an optimal capital structure. They
instead fund projects in the order prescribed by the theory—internal sources, then safe securities, then
risky securities. The next implication is that firms with large profits and cash flows from operations
will use less debt. A profitable firm with operating cash inflows greater than the amount required to
invest in its positive net present value projects will not need to use debt finance. The final implication
is that worries about underpricing and other difficulties when issuing debt securities and selling shares
of stock may motivate financial managers to carry financial slack. Building financial slack today,
which means the firm accumulates excess cash and short-term investments, is a rational solution to
possible underpricing and other difficulties when issuing securities tomorrow. Financial managers
know they will be required to fund internal investments in the future, and by storing financial slack in
the firm‟s balance sheet, they can quickly and easily fund these investments internally. There will be
no need to issue securities of any type to fund the investments.
We have examined two theories of capital structure, the trade-off theory and the pecking order
theory. Both are based on logical development and observations about the real world of business and
economics, but they conflict in their primary predictions about capital structure. The trade-off theory
holds that managers balance the benefits of debt tax shields with the costs of financial distress, and
that each firm has an optimal or target capital structure. The pecking order theory believes that
financial managers fund investments with internal funds first, then by issuing safer debt securities, and
then by issuing riskier equity securities. The pecking order theory holds that financial managers do not
pursue an optimal or target capital structure; the firm‟s capital structure results from the funds required
to invest in good projects, along with the firm‟s internal sources of cash and its debt capacity. It is
reasonable to ask which theory better explains capital structure in practice at real companies, and we
look at that in the next section.