Why a pecking order?
Managers know more about a firm's value than outside investors do. Since they're tempted to sell stock when it's overvalued, investors read a new equity issue as bad news, and the share price drops—an adverse selection problem. So firms tap retained earnings first, then debt, which is less sensitive to hidden information, and equity last. There's no target debt ratio.
Versus trade-off theory
Trade-off theory, which builds on the Modigliani–Miller theorem, predicts an optimal debt ratio balancing tax shields against bankruptcy costs. Pecking order better explains why highly profitable firms often carry little debt. But Frank and Goyal (2003) found small growth firms issue lots of equity, contrary to the theory.
FAQ
- Why do profitable firms have low leverage here?
- They generate enough internal cash that they rarely need to borrow.
- Why do stock prices fall after equity offerings?
- Investors infer managers think the stock is overvalued.
Sources reviewed: 2026-10-26
References
- Myers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), 187–221.
- Myers, S. C. (1984). The capital structure puzzle. Journal of Finance, 39(3), 575–592.
- Frank, M. Z., & Goyal, V. K. (2003). Testing the pecking order theory of capital structure. Journal of Financial Economics, 67(2), 217–248.