A PECKING ORDER PRIMER

by
Wm R McDaniel
Motivation
In his presidential address to the American Finance Association, Stewart Myers [1984]
recommended his pecking order theory as a superior solution to the capital structure puzzle. Since then,
much conceptual and empirical work has persuaded at least a significant minority of finance academicians
that the pecking order is superior to the competing optimal capital structure theories in explaining
management behavior with regard to financing policy. Further, these disciples think that the dynamic logic
behind the pecking order theory is superior to static capital structure theories. Nevertheless, the writers of
financial management texts have been slow to sanction the pecking order as a powerful model for
describing and prescribing financing policy. Most financial management texts have half of a chapter, a full
chapter or even more concerning the optimal capital structure theory. The coverage of pecking order
theory ranges from a couple of pages down to no mention at all.
The professorial adherents of pecking order can cover their approach to financing policy through
lectures. However, interested students like to have material also in a parallel written medium. This article
provides a source that instructors can assign for pre-lecture outside reading, can use as a reference after
the lecture for reinforcement and extension, or can use as a freestanding assignment. The paper is a
primer, describing the pecking order theory and the issues within it, identifying the costs it reduces, and
citing empirical evidence on the pecking order vis-a-vis the optimal capital structure theory. The paper also
extends the pecking order in several ways, including a demonstration of how pecking order changes when
the company's capital structure is near debt capacity. The paper makes no apology for my strong advocacy
of the pecking order theory over all optimal capital structure theories.
The Hierarchy
The pecking order acknowledges that dividends matter. It (like just about every other credible

source) has no advice on how to find an optimal dividend policy.

The pecking order assumes that

managers have found a suitable dividend and makes arrangements to declare and pay it before any other
financing decision.
The pecking order assumes that management has already identified projects, measured their net
present values (NPV) and ranked them accordingly. Managers set a time to decide which projects to
accept and also determine how to finance the chosen bundle of projects. The choice of financing sources
follows the hierarchy of the pecking order. Myers' original version of the hierarchy is:
1.

retained earnings; i.e., internal funds (cash, marketable securities)

2.

straight debt

3.

hybrids; i.e., securities that have characteristics of both debt and equity

4.

a seasoned equity offering1

In a doctrinaire application of the pecking order, management would completely exhaust a financing source
before it would tap the next source. A more realistic approach would be to use a source to a maximum
level of discomfort and then move to the next lower step. Also note that both the top and the bottom of the
pecking order are common equity sources.
An expanded version of the pecking order would be:
1.
2.
3.
4.
5.
6.
7.
8.

internal funds
leasing, revolving lines of credit and similar borrowing
bank term loans
debt placed with insurance companies, bank consortiums, etc.
public issuances of straight debt
hybrid securities preferred stock, debt with detachable warrants
hybrid securities debt with non-detachable warrants, convertible debt
and convertible preferred stock
seasoned equity offering (the financing of last resort)

Junk bonds are difficult to place. But because of the creditor realizes there's a better-than-typical risk that

Sometimes called a secondary equity offering. However, the term secondary offering also can mean
manager/owners' shares that sell as part of an IPO or seasoned equity offering. To avoid ambiguity, I call it a
seasoned equity offering throughout.
1

lenders will end up accepting equity positions in either a formal or informal reorganization, junk bonds
probably belong in category 7. Also, junk bonds frequently have warrants attached and put options.
The Hierarchy and Cost Minimization
To create value, managers should primarily concern themselves with investment policy; i.e.,
management of the business's operations.

This includes finding new projects for expansion, making

current operations as efficient and as effective as possible and terminating projects that are not earning
their cost of capital. Financing policy has much less potential as a value creating vehicle. After the receipt
of the proceeds from funding, financing is nothing but cash outflows. The best managers can do with
financing policy is to minimize costs.
Yet, the message of Modigliani and Miller [1958] and Miller [1977] is that because markets reward
correctly for risk and adjust for different tax treatments, the effective cost of equity is equal to the effective
cost of debt. The debate continues as to how much the real-world component costs of capital for a
corporation vary from the equivalency predicted by the ideal theories. Nevertheless, pecking order theory
begins with the assumption that there is little, if anything, to be gained by debt financing because of its
lower nominal rate or its tax status. A straightforward way of saying all this is: when one considers risk and
all income tax effects, the manager can do little to increase the firm's value by trying to minimize
component costs of capital 2. The manager should try to minimize the other costs associated with financing.
The other costs are share value dilutions in response to announcements of external financing, the flotation
costs (including underpricing) of external financing and management time and effort.

An important rule in finance is to "take the cheap financing." This rule supersedes any theory. But the rule is not
that the firm should use debt at a cost of 0.09 because it's less than equity at 0.15 these nominal costs of capital
have no adjustment for risk differentials nor income tax effects. The rule applies when the market sets the firm's
interest rate at 0.09 but, because of a subsidy or other market imperfection, a specific creditor will lend funds to the
firm at 0.075. A good example is a lease with a substantially positive net advantage of leasing. Even if the firm has
sufficient idle cash to buy the asset (assuming NPV > 0), it should lease this asset.
2

Announcement Effects
Empirical studies in the 1980s and 1990s formally confirmed and measured what security
underwriters had known for a long time: when the market realizes that a corporation plans the public

1.
2.
3.
4.
5.
6.
7.
8.

Description

Announcement
Effect

Flotation
Cost

Internal funds
Debt1
Debt2
Debt3
Public debt
Hybrid1
Hybrid2
SEO

-na0 to negl.+
0 to negl.+
0 to negl.+
0 to negl.small -1% to -2%
-2% to -4%

-na0 or biir
0 or biir
0 or biir
1% to 2%
1% to 2%
2% to 5%
3% to 15%

Underpricing
-na-na-na-na0.0125 coupon increase
modest
modest
0.025

Table 1
The Pecking Order & Issuance Costs
[1] na = not applicable
[2] negl.+ = some studies find a negligible positive effect
[3] biir = flotation costs built into interest rate
[4] negl.- = some studies find a negligible negative effect

issuance of some kinds of securities, investors bid down the price of that corporation's common shares.
The center column of Table 1 shows some ranges of these announcement effects from various formal
empirical studies. The eight categories on the left are the same as the expanded pecking order above.
The significant announcement effects are only for convertible preferred stock and convertible debt in
"Hybrid2" and seasoned equity offerings.

Again, junk bonds don't conveniently fit the pattern, but

researchers3 find an announcement of a pending issuance engenders a negative stock price effect (-1.5%)
similar to that of convertibles.
Announcement effects for Categories 7 and 8 are more severe than flotation costs. Announcement
reactions impact the entire corporate equity base, whereas flotation costs are on only the proceeds from the
For example, see Alex P. Tang and Ronald F. Singer [1993] "Valuation Effect of Issuing Nonsubordinated versus
Subordinated Debt," The Journal of Financial Research, Volume XVI, Number 1, Spring, 11-22.
3

new financing. The interesting thing to note is that managers who are attempting to avoid announcement
effects have a three-part pecking order: financing via Categories 1 through 6 causes little or no bad effects,
via Category 7 is decidedly worse, and via Category 8 is the worst choice.
The existence of unfavorable stock price movements in response the announcements of external
financing is an empirical fact. The explanations of why one observes these announcement effects are
more speculative. One explanation is the Price Pressure Hypothesis; i.e., the price decrease is a supplydemand phenomenon. The SEO creates a greater supply of shares for ISSUER Inc., and a convertible
issue portends a time in the future when more ISSUER Inc. shares will appear. Meanwhile, nothing is
increasing the demand from investors for ISSUER Inc. shares. These statements, taken at face value,
should cause the observed greater stock price reaction for SEOs and smaller reaction for convertibles. The
other categories of financing don't change the number of shares and should (and do) cause no reaction.
The exception again is junk bond issues, although frequently high risk financing includes equity
participation, such as warrants. Another observation supporting Price Pressure is that specialists on the
stock exchanges know that large block sale (buy) orders have significant downward (upward) effects on
stock prices in the short term.
Yet the Price Pressure Hypothesis is not as sound as it seems. True, there are more shares after
the SEO, but all shares, new as well as old, are different after the SEO. The corporation to which they have
a claim is likely larger now. The proceeds of the SEO buy new assets that add to corporate value. True,
there are more shares, but the shares have claim to more assets. A less likely possibility is that the
proceeds pay down debt, making the shares less risky. The argument that the SEO creates a larger supply
of shares is flawed in that the post-financing shares are a different economic good. A more theoretical
argument comes from efficient market advocates. They believe that investors buy shares of stock as
packages of risk and return, rather than as the literal claim on the cash flow stream from the corporation. If
the investor can find no stock that has the particular package of risk and return that he desires 4, he can

Constrained by the maximum risk-return tradeoff defined by the market as a whole.

create that package by buying some shares in Corporation AA, buying some shares of Corporate BB,
selling short some shares of Corporation CC and/or borrowing or lending. Thus, trading strategies create
essentially an infinite supply of packages of a particular risk and return. If the corporation adds to the
infinite supply through a SEO, it would have no material effect. Thus, efficient market advocates reject the
Price Pressure Hypothesis and require other explanations of the observed announcement effect from
SEOs.
Two related alternate explanations are Asymmetric Information Theories. Asymmetry means that
managers have valuable information that the general market does not, and therefore that information is not
built into the stock price. In the situations here, the asymmetric information is unfavorable, such that
managers think they should not reveal it directly. Nevertheless, potential investors closely watch managers'
decisions so that they can infer the nature and severity of the asymmetric information.
One of these explanations is the implied cash flow theory5. The cash flow identity is:
economic earnings + external financing = dividends + investments
In this statement, each term has a singular definition.

Not to be confused with accounting earnings,

"economic earnings" is revenue minus cash operating costs, less capital replacement investment, less
external financing cash outflows (interest payments, required principal repayments, lease payments,
preferred dividends) and less taxes.
equityholders have a claim.

In other words, it is the true cash benefits to which common

"External financing" is inflows from issuing shares and borrowing and

voluntary outflows for retirement of preferred and debt prepayment. "Dividends" is any cash dividends
and/or repurchase of common shares. "Investments" is capital expenditure for expansion and changes in
working capital. The identity is a forecasting version of a sources and uses of funds statement.
The rearrangement of the identity is useful for common stock valuation:
economic earnings - investments = dividends - external financing
The present value of the forecast stream of earnings net of investment (that is,

the stream of the

Merton Miller and Kevin Rock [1985] "Dividend Policy under Asymmetric Information," Journal of Finance,
September, pp. 133-152.
5

rearranged identity's left side) is an estimate of the market capitalization of the common stock (stock price
number of shares). Outside investors would love to know what managers know about the stream of
future economic earnings but can directly observe only a poor surrogate, last period's reported accounting
earnings. They would love to know what managers know about the future stream of investments but can
directly observe only the changes in past balance sheet reports in fixed assets and working capital.
Nevertheless, outsiders can directly observe surprises in external financing. Such a surprise lowers the
right side of the identity, and the left side of the identity must be lowered accordingly. Thus, investors
interpret the external financing as a signal of management knowing that future economic earnings will be
less than needed.6 Investors then bid the stock price downward in response to an external financing
announcement. Thus, managers seeking to avoid these announcement effects favor internal financing.
Theorists call these arguments the Implied Cash Flow explanation of market reactions to external financing
announcements.
Implied Cash Flow enforces the internal-funds-first tenet of Pecking Order. It has further support
from the empirical finding that larger proportionate SEOs elicit larger unfavorable price reactions, as the
cash flow identities suggest. On the other hand, Implied Cash Flow, taken alone, yields the weakest kind
pecking order, having only two categories: exhaust internal funds first, then use external financing.
Another asymmetric information explanation is Adverse Selection 7. In this theory, managers have
the flexibility to time external financing issues to take advantage of high market prices or low financing
rates.

The strongest case is when managers' unfavorable asymmetric information indicates that the

common stock price is higher than future corporate performance is likely to justify. In protecting the
interests of the existing shareholders, this is the time when managers are tempted to have a SEO.
Logically, external financing could just as well signal increased investment. Nevertheless, human nature is
such that investors readily believe revealed bad news but have a "show me" attitude about good news. Thus, they
initially conclude that the external financing is to cover future earnings shortfalls. The empirical evidence is that
when an SEO occurs with a stated intention of funding capital expansions, it still engenders a unfavorable stock
price reaction but not as unfavorable as for other stated intentions.
6

Stewart C. Myers and Nicholas S. Majluf [1984] "Corporate Financing and Investment Decisions When Firms
Have Information that Investors Do Not Have," Journal of Financial Economics, 13, pp. 187-221.
7

Nevertheless, when external investors observe the SEO announcement, they can guess the bad nature of
managers' information, and they bid the stock price down. A similar case concerns convertible financing.
All else equal, managers prefer to offer a lower conversion ratio; thus, they pick a time when their
asymmetric information suggests the stock price is too high. Outside investors bid the stock price down,
because they again perceive the financing announcement as bad news, although not quite as bad as an
equivalent SEO. The story is weakest for reactions to debt financing: managers borrow when creditors are
unrealistically optimistic about default risk and the debt's interest rate is too low.

Outside investors,

observing managers' actions, conclude that the firm is not as safe as it seemed and bid stock prices down
some. Finally, when managers use internal funding, outsiders have no opportunity to draw conclusions
about timing, and there is no unfavorable reaction.
The Adverse Selection theory has managers trying to avoid announcement effects by following a
more nearly complete pecking order. Financing is first by exhausting internal funds, then by using debt
instruments, then preferred stock, next by issuing convertibles and finally by SEO. Adverse Selection does
not work as well for defining where leases and junk bonds fall in the hierarchy. Importantly, Adverse
Selection implies that the category of external financing used (not the amount of external financing, but the
kind) reveals the nature and severity of the unfavorable asymmetric information. Contrary to empirical
evidence, the size of the issuance is not important in determining the magnitude of the announcement
effect.
All three theories, Price Pressure, Implied Cash Flow and Adverse Selection have some attractive
traits for conjecturing about the causes of price changes in response to external financing announcements.
Each of the three has some drawbacks. A reasonable response to these paradoxes is to think that all three
has some real-world validity.
Flotation and Other Issuance Costs
Another cost type that managers might try to minimize is issuance costs. At the top of the pecking
order, internal funds in the form of an available cash balance have no "issuance cost" and in the form of

marketable securities has a minimal brokerage fee for sales. Non-public debt issues or leasing have any
administrative fee built into their interest rates or lease payments; rarely, a lender does charge a direct
upfront issue cost. As Table 1 shows, flotation costs become more significant as one goes down the
pecking order. Junk bonds and "financial engineering" instruments frequently have flotation cost on the
order of five percent. SEOs typically range from about three percent to 15 percent with a mean of about
7.5 percent and a strong mode at 7.0 percent. The eight-category pecking order is almost completely
consistent with the goal of financing at minimum issuance costs.
Management Time and Effort
Since management is likely to create more shareholder value by concentrating on investment
policy, time spent tweaking the capital structure is not well spent.

Management time and effort is

expensive. Negligible management time and effort goes into financing through internal funds. Drawing on
existing lines of credit is almost as easy. As one moves down the pecking order, the contracts get more
complex, the rate determination on debt gets more complex, and managerial effort becomes greater. The
motive of saving valuable management time and effort is strongly consistent with following the pecking
order.
Managerial Capitalism
Classic agency theory would have managers operating the corporation as much for their own
benefit as possible. Managers having this goal possibly could use the pecking order financing pattern to
enhance their control of the corporation, and thus their ability to go toward the self-enriching goal. In
corporations where shareholders have little de facto control8, financing via internal funds puts no
constraints on management's operating decisions.

Down the pecking order, debt financing often has

restrictive covenants that can limit management's freedom in operating decisions.

At the level of

convertibles and more so at the SEO level, potential new shares make the proxy mechanism conceptually
more likely to be effectual. These notions support that a self-seeking manager would try to stay closer to
In today's corporations, cases where the proxy mechanism is a threat to management control are rare but not
negligible.
8

the top of the pecking order.

Yet the managerial capitalism explanation of pecking order behavior does not bear up under close
scrutiny. Debts' restrictive covenants also can pinch shareholder wealth, such that avoiding the covenants
is not just to allow agent-managers to enhance their own wealth. Second, currently institutional investors
use their portfolio positions, rather than their raw voting power, to coerce managers to operate the
corporation primarily for the benefit of common stock owners. A convertible issue or SEO does reduce or
increase this influence. Finally, a firm that over time stays close to the top of the pecking order is likely to
have a nearly all-equity capital structure. If the managers are running this corporation poorly and for their
own benefit, it is a perfect leveraged buyout candidate. After the LBO, the acquirer will surely rid itself of
the poor management team.

In conclusion, agency theory reasoning doesn't explain nor recommend

pecking order as a financing policy.

Observations about Availability
The notion of availability does not relate to pecking order vis-a-vis cost minimization, but it does
have strong explanatory power for some observed pecking order behavior. In this context, the description
of "availability" is that not every kind of financing is available to every firm. Perpetual preferred stock
financing is mostly by regulated public utilities. SEOs are unavailable to private corporations, and certainly
unavailable to partnerships and proprietorships.
Internal financing is the first and perhaps only choice of financing to many small proprietorships
and partnerships. Some of these, as they enhance their collateral value, can then tap local bank borrowing.
Leases, on moveable, multi-application assets, are widely available to small companies. Firms must be
larger and more well established before they can finance via the midlevels of the pecking order. The
financing choices at the bottom of the pecking order are available to only large public corporations. Thus,
the firm's size and the reputation that comes with size to a great extent determine how far down the pecking
order it can go. The firm's capital ration is often a function of its access to capital markets and what kinds
of financing vehicles are available.

10

How the Firm's Operating Traits Relate to the Pecking Order

In this section, the assumption is that managers are following the pecking order as their financing
policy.

11

Earnings, the Pecking Order and Capital Structure

Corporations with consistent, high earnings over time would finance new projects from sources
near the top of the pecking order. Some of the most successful firms would never use external financing.
Over time, the earnings retained continue to add to the equity base. As any old debt matures, it disappears
from the capital structure. Thus, high earnings companies' capital structures evolve toward 100 percent
equity. They suffer little threat of hostile takeover, because their stock prices are high and potential raiders
have no way of recouping the takeover premium needed to gain control. In successful LBOs, the raiders
make the target firm more efficient to recover the higher-than-market price they had to pay for the common
stock.
Corporations with low earnings must frequently finance their new projects with external financing.
Their capital structures will have more debt and are more likely to be complex with various hybrid financing
vehicles. Firms with high earnings some years and low earnings in others will have capital structures that
vary significantly through the years. Optimal capital structure theory predicts that each company's actual
capital structure remains relatively stable over time.
Dividends, the Pecking Order and Capital Structure
Corporations with high payout ratios will have less earnings to reinvest. Their dividend policy
forces management to go further down the pecking order to fund new projects. Thus, high dividend
corporations will borrow more from year to year and find their capital structures to be more leveraged.
Capital Rationing
Firms with low earnings are more likely to reject a project whose NPV is positive, because the NPV
is not large enough to cover the issuance costs of a public issue to finance the project. A corporation with
ample internal funds could accept this project. Likewise, a corporation with a high dividend payout is more
likely to reject good projects because of issuance costs. The existence of issuance costs causes a natural
de facto capital ration. Firms with ample internal funds who can finance all projects near the top of the

12

pecking order do not suffer the ill effects of this capital ration. Their accepted good projects increase future
earnings, which in turn lead to future availability of internal funds. Their capital structures can stay at a
nearly all-equity state. Firms who do suffer from this capital rationing will reject some good projects and
thus will not enjoy the added future earnings. Since they will not have the expanded future internal funds,
their future financing will be through more debt. Their capital structures secularly contain significant levels
of debt. Nevertheless, the proportion of debt can vary markedly over time.
In summary, the pecking order theory predicts that many highly profitable companies will have
stable capital structures of all or nearly all common equity. Corporations with high payout ratios are more
likely to have significant debt. Corporations with significant debt will have capital structures that vary
markedly over time.
Empirical Evidence
The empirical evidence that firms follow the pecking order is strong.

Macroeconomic data,

gathered by the Board of Governors of the Federal Reserve System [1983-1998], give robust indirect
support. Internal sources finance more than 70 percent of corporate investments in every year (in 1991,
internal financing was 97 percent). Debt dominates the remaining financing from all external sources. New
equity financing, including not only SEOs, but also initial public offerings (outside the scope of pecking
order and capital structure theories) and preferred stock (both convertible and non-convertible), is never
more than 6 percent of total annual external financing. In 13 of the 16 years, the dollar amount of common
share repurchases exceeds the proceeds of all equity issuances.
Studies that directly focus on pecking order include Baskim [1989] 9, who synthesizes some
previous studies and adds the results of his own. He finds that companies that have had sustained high
growth, ceteris parabis, have higher debt ratios, consistent with the pecking order prediction that heavier
external funding will be primarily through debt instruments. He finds that firms with high past profits have
lower debt ratios, consistent with the pecking order prediction that high availability of internal funds
Jonathan Baskin [1989] "An Empirical Investigation of the Pecking Order Hypothesis," Financial Management,
Volume 18, Number 1, Spring, 26-35.
9

13

decreases needed borrowing. He finds that companies that paid higher dividends typically borrowed more.
Baskim also discloses a number of studies that discredit the notion that managers actively seek an optimal
capital structure. A very striking example of these results is his finding that capital structure variations
within an industry are little different from variations within all corporations. Optimal capital structure theory
demands a significant clustering of capital structures around the industry average debt ratio.
Shyam-Sunder and Myers' [1999]10 empirical work shows that debt dominates external financing.
Second, they note that the phenomenon of financial leverage magnifies operating profits; thus, one would
expect that companies with more debt financing would have higher profitability. They find empirically that,
on the contrary, the more profitable businesses use much less debt. Pecking order easily explains their
finding.
Two things seen in practice seem to support optimal capital structure theory over pecking order
theory: recapitalizations and LBOs.

Optimal capital structure theory predicts that underleveraged

corporations (the current debt ratio is less than the optimum) borrow and use the proceeds to buy back
common shares. The transaction should result in a lower weighted average cost of capital and a higher
stock price. Overleveraged corporations issue shares, using the proceeds to prepay debt. This transaction
should also result in a lower weighted average cost of capital and a higher stock price. In a comprehensive
empirical study of recapitalizations, Masulis [1980]11 found that announcements of debt-to-replace-stock
transactions typically engendered positive responses in stock prices; however, stock-to-replace-debt
announcements engendered negative responses, contrary to optimal capital structure theory predictions.
At face value, his findings support neither pecking order nor optimal capital structure.
A deeper examination of Masulis' work shows that the observed phenomena have less to do with
routine financing policy than one thinks initially. First, at a big-picture level, his sample was over a 14-year

Lakshmi Shyam-Sunder and Stewart C. Myers [1999] "Testing Static Tradeoff against Pecking Order Models
of Capital Structure," Journal of Financial Economics, Volume 51, Number 2, February, 219-244.
10

Ronald W. Masulis [1980] "The Effects of Capital Structure Change on Security Prices" Journal of Financial
Economics, Volume 8, 139-178.
11

14

period, when there were approximately 10,000 traded corporations in the United States and Canada for
convenience, combine these to be a potential 140,000 event-years. He found only 85 usable debt-forcommon-equity exchanges and only 57 common-stock-for-senior-security exchanges. Either not many
managers know the gains to be made via recapitalizations or they think there is little to be gained through
recapitalization. Second, the predominance of tender offers contaminates the sample of debt for common
stock. When the corporation offers a 15 to 20 percent premium for its stock, the "dividend" effect causes
high positive abnormal returns. Third, Shah [1994] 12 found that firms in or approaching financial distress
dominate the sample of stock-for-debt exchanges. These announcements are likely to be parts of informal
reorganizations, and the likely melancholy recipients of the debt are the corporation's existing creditors.
The cause of the stock price drop is likely that shareholders see their ownership vastly diluted and also
discern more unfavorable information about the hard times the company is going through. In sum, the
relatively few recapitalizations are within the purview of dividend policy and financial distress management
rather than general financing policy.
The popular financial press often cites the benefits of debt financing to explain why an acquirer
used an LBO to purchase its target. A naive extension of this invalid explanation is to say that the LBO
brings the target closer to its optimal capital structure. In fact, the LBO usually results in the target's postacquisition capital structure close to its debt capacity, far above the imagined level of the optimal capital
structure. Often the LBO plan is to sell underperforming assets, using the proceeds to pay down the debt.
Overall, a better explanation for LBOs is that the acquirer uses debt as a tool for takeover. The economic
gains from the LBO are to be from improving the corporation's operating characteristics.
Pecking Order in Concert with a Radical Optimal Capital Structure Theory
The Miller [1977] model of capital structure assumes that the costs of financial distress are
negligible. He cites an empirical study of 13 railroad failures where the reorganizations destroyed an
average five percent of corporate value. The probability of failure varies directly with the debt in the capital
Kshitij Shah [1994] "The Nature of Information Conveyed by Pure Capital Structure Changes," Journal of
Financial Economics, Volume 36, Number 1, August, 89-126.
12

15

structure. The cost of capital effect of a potential failure then would be the probability of failure times 0.05
indeed, an insignificant amount.
Clearly, Miller's position is untenable for the smallest of businesses in financial distress. The cost
of the services of a bankruptcy attorney could destroy many a proprietorship's net worth. Just as important
is that, for all businesses, financial distress has indirect operating costs: managers spend time dealing with
creditors, attorneys and accountants rather than trying to improve the company's operating characteristics;
potential clients and trade creditors hesitate to transact with a company whose warranties and trade notes
may soon become invalid; and consumers, perhaps wrongly, infer an inferiority to the company's products
because the financial trouble. An empirical study by Andrade and Kaplan13 [1998] shows that for large
corporations, the loss from realized financial distress averages less than 20 percent of pre-distress value.
Again, potential financial distress would affect the cost of capital by the probability of distress times the its
cost. Thus, potential business failure's effect on capital structure policy for major firm's is small, but not
negligible; for smaller businesses, its effect is significant.
Thus, the statement above, "because markets reward correctly for risk and adjust for different tax
treatments, the effective cost of equity is equal to the effective cost of debt," requires some modification. 14
The risk incurred via debt financing is two-fold: the apportioning of existing operating risk over a smaller
equity base (this appears as higher volatility in earnings to shareholders) and the risk of value destruction
caused by financial distress. The Modigliani and Miller [1958] and Miller [1977] proofs ignore the later facet
of financial risk.
Therefore, debt financing, allowing for differences in tax treatments, risk from higher earnings
volatility and risk from losses associated with financial distress, is uniformly more costly than equity
financing. The excess cost increases at an increasing rate with leverage in the capital structure. Of

Gregor Andrade and Steven N. Kaplan [1998] "How Costly is Financial (Not Economic) Distress? Evidence
from Highly Leveraged Transactions that Become Distressed," Journal of Finance, Volume 53, Number 5, October,
1443-1493.
13

14

In the traditional of capital structure theory, only debt and common equity financing are under consideration.

16

course, the excess cost cannot be discerned by comparing the nominal cost of debt to the nominal cost of
equity. It becomes obvious in the resulting weighted average cost of capital (WACC), which increases at
an increasing rate with leverage (Figure 1). Another way of saying the same thing is that corporate value
decreases as leverage increases, if one considers only capital structure effects. Yet another way of saying
it is that common stock price, p, drops at an increasing rate as leverage increases, if one considers only
capital structure effects. The mathematical way of saying it is:
VL = VU - {B/V}
With the financial distress function, {B/V}, having the characteristics:

> 0
(B/V)

and

2
> 0
(B/V)2

The result of this radical view is that the optimal capital structure is 100 percent equity. But minimizing cost
of capital by maintaining a perfect capital structure is not the only issue in financing policy.
First, imagine a corporation whose current capital structure is well below debt capacity; for
example, one whose present leverage position is a "Normal Capital Structure" in Figure 1. Before the
discussion of what directly influences managements financing decisions, consider what happens routinely
through time. The result of increasing markets for products and of previously accepted NPV > 0 projects is
that sales less cash costs should be netting a positive cash flow. Routinely, working capital investments
and, perhaps some fixed asset investments, are occurring in response to the higher sales levels. The
excess cash inflow netted from sales is thus internal equity financing for the routine investments. This
transaction increases V = B + E without changing B, and B/V decreases. The leverage decrease moves
the corporation nearer to its all-equity optimal capital structure, and consequently the stock price goes up,
p > 0. Another name for this will be a positive capital structure effect or CSE > 0.

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Another routine happening is the treasurer pays principal payments as they fall due. This transaction
decreases B/V as well, and its

CSE

> 0. If the corporation still has excess cash flow from operations that it

puts into reserve as cash or as liquid marketable securities, the activity also is creating internal equity,
whose CSE > 0. Passive financial management makes the capital structure evolve toward all-equity.
Now, assume managers have identified a package of projects whose NPVs exceed zero. The
Table 2: Financing Policy for a Corporation Currently Having a Normal Capital Structure
Internal
Funds

Debt
Financing

External Equity
Financing

1. no CSE
2. no FC
3. no UAE

1. low CSE < 0

2. low FC
3. no or low UAE

1. low CSE > 0

2. high FC
3. high UAE

Conclusion: a pecking order of internal funds, then debt and SEO as the financing of last resort.

question is how to best finance some or all of the projects. For corporations at the "Normal Capital
Structure", modest changes in leverage have little effect on the stock price. This idea appears in Figure 1
by the WACC curve being almost flat. Moderate amounts of borrowing move the capital structure away
from the all-equity optimum, but the resulting price drop, p, is small; i.e., low

CSE

< 0 in Table 2. A SEO

has exactly the opposite effect. Using internal funds to buy new assets does not change capital structure,
because the cash and near cash are already part of the equity base. But cost minimization in financing
includes flotation costs,

FC,

and unfavorable announcement effects,

UAE,

as well as

CSE.

Total cost

minimization creates a pecking order of internal funds first, then debt financing and SEO as the financing of
last resort.

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Financing policy for firms that are the near debt capacity differs from those at normal capital
Table 3: Financing Policy for a Corporation Currently Having a Capital Structure near Debt Capacity
Internal
Funds

Debt
Financing

External Equity
Financing

1. no CSE
2. no FC
3. no UAE

1. high CSE < 0

2. moderate FC
3. high UAE

1. high CSE > 0

2. moderate FC
3. high UAE

Conclusion: a pecking order of internal funds, then equity-for-debt exchange with current creditors
and more debt as the financing of last resort.

structures. Figure 1 shows that at capacity, changes in capital structure engender large

CSEs

the WACC

curve is relatively steep. Table 3 reveals that internal funds are still the financing choice, even though
management should strongly consider using these to reduce debt immediately. Nevertheless, firms near
debt capacity are unlikely to have much excess cash. Markets are unlikely to have interest in SEOs for
such corporations. The likely prospect is that managers should negotiate with creditors to structure an
exchange of equity for reduced interest rates, longer terms to maturity and debt forgiveness.

Such

transactions increase equity and decrease debt. The transactions require only moderate administrative and
flotation costs.

Debt is the financing of last resort.

It is likely to require the approval of existing

creditor/equityholders, and likely to be junk bonds with high flotation costs. With these understandings in
mind, one can think of the revised pecking order for these corporations as internal funds first, equity
exchanges next and new debt as the financing of last resort.
In conclusion, the classic pecking order applies to most firms. Only when the corporation is near to
debt capacity does the hierarchy change.

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WACC vs. Capital Structure (B/V)

A Radical View
Figure 1
WACC
0.20
0.15
0.10
0.05
Debt/Value

0.00
0

0.2

0.4

Normal capital structure

0.6

0.8

Near-capacity capital structure

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