The pecking order theory tries to stipulate why firms adhere to a certain capital structure and what governs its choice in raising funds to finance projects
The pecking order theory stipulates that a firm prefers internal financing as oppose to external financing. Internal financing is out of the eye of the investors and the market and therefore carries fewer signals. When a firm does not have sufficient internal financing to pursue all positive NPV projects, it will favour debt over equity. If it has surpassed its debt capacity it will choose to raise funds using the third and final method; equity.
Raising equity is recognised negatively in the market because it carry’s signals. Management are likely to have more information and more understanding of the operations of the firm in comparison to the market. If they have a more accurate valuation of the firms share price, they would have an incentive to raise equity when they believe the stock price is overvalued and avoid raising equity when the stock price is undervalued. The market perceives this asymmetric information and so when the firm chooses to raise equity we normally see a fall in the stock price. For this reason the firm has a disincentive to raise equity. By contrast, debt is determined predominately by market values. The cost of debt is determined by the market value of similar such debt, and as a result cannot be manipulated by shareholders. For this reason it carries less signals then equity
Therefore the pecking order of financing are:
1. Internal financing
2. External debt
3. External equity