Pecking order theory
Principles of Finance glossary · Cost of Capital & Capital Structure
Definition
The proposition that firms prefer internal funds, then debt, then equity, owing to information asymmetries (Myers-Majluf 1984).
Pecking order theory in plain English
When a company needs money, this theory says it has a favorite order (a "pecking order") for where to get it: first its own saved-up cash, then borrowing (debt), and only as a last resort selling new shares (equity). Why that order? Because the people running the company know more about how it's really doing than outside investors do — so if managers suddenly sell new shares, investors get suspicious and think, "Uh oh, do they know the stock is overpriced?" and the price drops. It's like selling your used bike: buyers assume you're only selling because you know something's wrong with it, so you'd rather dip into your savings than face that suspicion. This idea comes from economists Myers and Majluf (1984).
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