Pecking Order Theory and Choosing the Financing Method

A company has an attractive project and needs money. It could use profits it has kept, borrow, or issue new shares. The previous topics asked what the ideal mix of debt and equity would be and found that, in theory, there may be an optimum.

But managers do not usually start from an ideal mix: they start from a project and a balance sheet, and ask which way of paying for it is easiest, cheapest and least likely to cause trouble. The theories in this topic describe how financing choices are actually made, and each predicts something different about how profitable companies are financed.

The static trade-off theory says that companies aim at an optimum gearing; the pecking order theory says that they do not, but follow a rank order of sources; market timing theory says that they issue shares when the price is high; and agency theory explains choices by the conflicts between shareholders, managers and lenders.

This topic explains each, what each predicts, how they would lead to different financing of the same project, and a practical checklist for choosing a method of finance, with worked examples. The next topic turns to the financing problems of small and medium-sized enterprises.

Why companies have different gearing levels was the subject of November Diet, 2025, Question 5 (15 marks). Read Modigliani and Miller with tax, market imperfections and gearing in appraisal first.

Static trade-off theory

Static trade-off theory argues that there is an optimal capital structure for each company. The benefits of debt are mainly the tax relief on interest: because of it, the weighted average cost of capital falls as gearing rises.

The costs are those of financial distress: the higher the debt, the more likely it is that the company cannot pay interest and repay loans on schedule, so lenders raise the rate or refuse to lend. The optimum is where the marginal benefit of extra debt equals its marginal cost.

The optimum differs between companies:

• a very profitable company can take more debt, because the costs of distress do not become significant until gearing is very high
• a company with low profits, on the other hand, gets little benefit from the tax shield (it has little profit to shelter), faces a higher risk of distress, and will avoid borrowing
• it may rely on retained profits and even decline a positive net present value (NPV) project that it cannot finance that way

What the theory says:

• companies have an optimal level of gearing
• in financing a new investment they try to maintain or reach it
• the optimum is higher for profitable companies
• so there is a positive correlation between profitability and gearing

Pecking order theory

Pecking order theory, put forward by Myers in 1984 as a challenge to static trade-off, says that companies have an order of preference for sources of finance:

1. First: retained earnings, the most preferred source;
2. Second: debt capital; and
3. Third: a new issue of shares, the least preferred.

So a company with a positive-NPV project will fund it from retained profit if it can; if not, it will borrow; only if neither is available (weak cash flows, low profits) will it issue shares. The reasons are partly practical: retained profit is convenient, needs no issue costs and no approval; a loan is simpler and cheaper to arrange than a share issue and the interest has tax relief.

Another reason, and the deeper one, is asymmetric information: managers know more about the company than investors do. If investors suspect that managers issue shares only when the shares are overvalued, a new issue is taken as bad news and the price falls.

A simple example: a company is worth ₦100 if its prospects are good and ₦60 if bad, with equal chances, and the market, unable to tell, values its shares at the average, ₦80. A good company issuing shares at ₦80 sells them ₦20 below their true value, so it prefers retained profit or debt; only a bad company is eager to issue at ₦80 (it gains ₦20).

The market sees this and marks down any issuer, so a good company avoids issuing equity, which is the pecking order. Debt does not suffer from the same problem, since it promises fixed payments regardless of the true value.

The theory implies that there is no optimal gearing: gearing is the result of a series of financing decisions. A profitable company with plenty of retained profit needs less debt, so there is a negative correlation between profitability and gearing, the opposite of the static trade-off prediction. Empirically, profitable companies often are less geared, which supports pecking order.

Market timing and agency

Market timing theory says that the choice of financing method is driven by opportunities in the capital markets, which arise from information asymmetries. Managers may know when the shares are over-valued or under-valued relative to the company’s prospects, so they issue new shares when the price is high and buy shares back when it is low.

Gearing is therefore the result of past market timing and there is no target.

Agency effects (Jensen and Meckling, 1976). Conflicts of interest exist between shareholders, who want high returns and share value, managers, who may prefer remuneration, status and a quiet life, and lenders, who want the company to pay its debts in full and on time and fear that borrowed money will be invested in high-risk ventures. These conflicts affect the choice of finance:

• Shareholders, especially when managers own shares, may prefer debt to avoid dilution, and because debt fixes cash payments and leaves less free cash for managers to spend on perks.
• Lenders may oppose new borrowing that tempts shareholders to take on riskier projects (since shareholders gain from the upside and lenders bear much of the downside); they limit it by covenants and higher interest.

Jensen and Meckling argued that the optimal structure trades off not only the marginal benefits and costs of debt (static trade-off) but also the agency costs of debt (covenants, monitoring, risk shifting) against the agency costs of equity (managers’ free spending, the need to monitor them).

Comparing the theories on one project

A company has debt of ₦12bn and equity of ₦30bn (market values) and an investment of ₦6bn with a positive net present value (NPV). Retained profit available after dividends is ₦2.5bn. Gearing is 12 ÷ 42 = 28.6%.

• Pecking order: use the ₦2.5bn retained, then borrow the other ₦3.5bn, and issue no shares.
  Debt rises to ₦15.5bn and gearing, on unchanged equity of ₦30bn, to 15.5 ÷ 45.5 = 34.1%.
• Static trade-off with a target gearing of 30%:
  after the project the total is 42 + 6 = ₦48bn, so target debt is 0.30 × 48 = ₦14.4bn: borrow only ₦2.4bn, use the ₦2.5bn of retained profit and raise the remaining 6 − 2.4 − 2.5 = ₦1.1bn by a new share issue.

So the same company would issue shares under one theory and not under the other. Which is right depends on the company: those with high costs of distress or a clear target (regulated firms and banks, for example) behave more like the trade-off; many companies with ample retained profit behave like the pecking order.

Choosing a method of finance: a checklist

• Cost: the after-tax cost, issue costs and fees of each source.
• Risk: the effect on gearing, interest cover and the covenants; the risk of being unable to repay.
• Availability and capacity: retained profit, borrowing capacity (security and cash flows), the state of the market for shares and bonds.
• Control and dilution: new shares may change the ownership.
• Timing and flexibility: the speed at which the money is needed, the ability to repay early, and whether the finance matches the life of the asset.
• Information and signals: what the market will infer from the choice.
• Tax: relief on interest; limits on deductibility and withholding taxes.
• Regulation: approvals for share and bond issues, listing rules, central bank rules.

In Nigeria, with high interest rates (the Monetary Policy Rate was 23% from 22 September 2026), many larger companies have turned to commercial paper and bonds because of the cost and availability of bank credit, while smaller companies rely mostly on retained profit and owners’ funds, consistent with the pecking order.

The ideas in more depth

Why the theories are not mutually exclusive

Each captures a real force. Companies do care about distress costs and tax (trade-off), do find retained profit and debt easier than new shares (pecking order), do issue shares when prices are high (timing) and do respond to the demands of lenders and the temptations of managers (agency). Actual gearing reflects all of these, and differs between industries and between companies of different sizes and ages.

A good answer in the examination identifies the forces at work in the company described and says which theory best explains its behaviour.

Why retained earnings are not free

Retained earnings have no issue costs. But they are not costless: shareholders could have received the profit and reinvested it, so retained profit has an opportunity cost, the cost of equity. The pecking order reflects convenience and information problems, not a belief that retained earnings cost nothing.

Sources and references

• Myers, S. C. (1984), “The capital structure puzzle”; Jensen, M. C. and Meckling, W. H. (1976), “Theory of the firm”. The rules on share issues, bonds and commercial paper are those of the Investments and Securities Act 2025 and the Securities and Exchange Commission. The Monetary Policy Rate is set by the Central Bank of Nigeria.

These points are stated as at 5 November 2026.

Worked examples

1. Retained profit first. ₦2.5bn.
2. Then debt.
   6 − 2.5 = ₦3.5bn; no new shares.

1. Target debt.
   0.30 × 48 = ₦14.4bn.
2. New debt.
   14.4 − 12 = ₦2.4bn.

1. Balance.
   6 − 2.4 − 2.5 = ₦1.1bn by a share issue.

How to answer in the exam

• State each theory with its prediction on the optimum and on profitability and gearing.
• Apply to the company: its profits, retained earnings, cash flow, assets, size and market.
• Give reasons for different gearing: industry, tax position, asset type, growth and management attitudes.
• Conclude which theory fits best and note that actual behaviour reflects several.

Common mistakes in the exam

• Confusing the predictions of trade-off and pecking order on profitability.
• Saying that pecking order has a target gearing.
• Describing agency theory without naming the three groups and their conflicts.
• Treating retained profit as costless.
• Giving only theory, with no application to the company in the question.
• Ignoring the information (signalling) argument for the pecking order.

Quick revision

• Static trade-off: optimum gearing; positive link between profit and gearing.
• Pecking order: retained profit, then debt, then shares; negative link.
• Market timing: issue shares when overvalued.
• Agency: conflicts between shareholders, managers and lenders.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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