Why Companies Prefer Debts-an Introduction to the Pecking Order Theory

Which may sound strange to a person with a non-economic background is a really fascinating phenomenon. The “pecking order theory” suggests that there is a hierarchy of capital, which a company is going to spend first!

  1. Internal Capital
  2. Debt
  3. Equity

According to this theorem companies try to use internal capital. If the amount of internal capital is not sufficient the company will be forced to look for external capital. In theory a company will always choose debt over equity, which is also compatible with the trade-off theory of capital structure1.

Why should companies avoid equity? The equity operator is investing money and receives shares in return.

The pecking order theory is taking into account that there is some sort of market failure, due to the asymmetric information known by internal and external people. In order to be able to understand this, we should get some information about private equity (or venture capital).

Private equity is a cluster of money which is used to buy-out parts of a company. The goal of private equity operators or venture capitalists is non-industrial, they will try to sell their shares and make profit.

According to Caselli there are 4 benefits of private equity operators.

  1. Certification effect: hence operators check the finances thoroughly, it is awarding for a company, if the investor starts to fund the company
  2. Knowledge effect: the operator is going to ad value to the company by his either industrial or financial knowledge
  3. Network effect: due to the network of the operator the company will profit by gaining new contacts
  4. Financial effect: by all these actions value is added to the company

As you can see private equity operators are keen on changing things in the company (may it be the management or the structure of the organization).

Since getting a private equity investor signals to the market that the company is not relying on its own management or staff, it is causing concerns to external people. If the organization would run well, there would not be any need for an private investor.

The phenomena of pecking order theory may be even a market failure due to asymmetrical information, as mentioned above.

Let me know what your opinion on this topic is.

1.the trade-off theory of capital structure is a theory suggesting, that if the cost of debt is not higher than the outcome by the fund project, the entrepreneur is going to take the debts.

Sources: https://books.google.at/books?id=fi4sDwAAQBAJ&pg=PA6&lpg=PA6&dq=knowledge+effect+private+equity&source=bl&ots=f-Ge9fbtlF&sig=ACfU3U3fdCB3fSwWRiXUAH5axKw9Oi_onA&hl=de&sa=X&ved=2ahUKEwj1uoqyov3pAhUIy6YKHTNGCz4Q6AEwBXoECAsQAQ#v=onepage&q=knowledge%20effect%20private%20equity&f=false

Published by chess

Hi, I am an economics student in his 20's and eager to learn the basics of finance and investing. Would be glad to hear your opinion on my posts

3 thoughts on “Why Companies Prefer Debts-an Introduction to the Pecking Order Theory

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