Pecking order theory: why retained earnings come before debt, and shares come last

Pecking order theory holds that a company does not target an "optimal" share of debt but works its way down a ladder of funding sources from the top. Retained earnings are spent first, then debt is raised, moving from bank loans to bonds, and only once debt capacity is exhausted are new shares issued. The order is set not by the CFO's habits but by information asymmetry: management knows more about the quality of the assets and the real prospects of a project than an outside investor does, and every step down the ladder costs more precisely because it means persuading someone who knows less.

Where the order itself comes from

The logic was set out by Myers and Majluf in 1984, building on an earlier observation by Donaldson (1961): in practice, firms financed growth from internal funds far more readily than models of optimal capital structure predicted.

The mechanism works like this. An investor cannot tell a company with undervalued assets from one with overvalued assets. So the investor applies a "just in case" discount to any new share issue, and the placement price ends up below what management considers fair. If management acts in the interests of existing shareholders, it will forgo the issue even when the project is sound in itself: the gain would go to the new shareholders who bought too cheaply. Hence the negative share-price reaction to the announcement of a secondary offering, and the preference for sources whose cost depends less on what the market thinks of the company.

In this sense, internal earnings require no persuasion at all. Debt requires less: the lender holds a fixed claim, and its repayment depends little on whether the company turns out to be outstanding or merely ordinary. A share is a residual claim, and its price rests entirely on an assessment of the future. The more a claim depends on the unknown, the more expensive it is to sell to an uninformed buyer.

The rungs and what lies between them

Between pure debt and pure equity lies an intermediate band: convertible bonds, mezzanine financing, preferred shares, a bridge loan against future permanent financing. The theory predicts that a company will tap this band before turning to new equity, and the order within the band is the same: the closer an instrument is to a residual claim, the later its turn comes.

Several observable signs follow from this. Dividend policy becomes "sticky": payouts are not used to regulate the investment programme, because cutting them sends a signal in itself. The company keeps a reserve of unused debt capacity as an option on future opportunities. Leverage becomes not a target but a residue of the company's profit history: a profitable company with moderate capital expenditure looks lightly indebted not because it chose that structure, but because it never had to climb down the ladder.

How this differs from trade-off theory

Trade-off theory speaks of an optimum: the interest tax shield weighed against the costs of financial distress. Capital structure has a target point to which the company returns. The pecking order assumes no target point at all. The distinction can be tested: under trade-off theory, leverage should revert towards the norm after a deviation; under the pecking order, it should drift with earnings and investment. The empirical evidence lends partial support to both; the pecking order does a better job of explaining large, mature companies and a worse one for young and growing companies, which are precisely the ones that readily issue shares.

How to read it for a Russian company

The test is based on financial statements and accompanying documents, not on management statements. It is worth looking at the sources of funding for capital expenditure in the cash flow statement, at the trend in the debt burden and at the history of fundraising. These are covered in the sections on issuer reports and the debt market. Dividend "stickiness" shows up in how payouts behave in a weak year: upcoming dates are collected in the dividend calendar, and confirmations in

The price at which shares would have to be placed is the key variable of the last rung. For SBER the benchmark is 3,92; the cost of the debt rung is set by the funding rate and its relationship with the refinancing rate. The general picture across securities is in the stocks section, and definitions are in the glossary.

One separate caveat: the platform's database contains no quantitative test of pecking order theory on a Russian sample, so claiming that it works more strongly or more weakly here than in developed markets would be invention. What can be tested is individual companies, through their own fundraising history.

Where the theory breaks down

There are several limitations. First, it works poorly where internal funds do not exist by definition: a loss-making early-stage company goes straight to equity financing, and that is rational. Second, the market is sometimes shut: when the issuance window is narrow, it is not the company that chooses the order. Third, corporate governance can turn the logic upside down: management with an interest in scale will avoid the discipline of debt and prefer a share issue. Finally, at state-owned companies, decisions on share issues and dividends are taken outside the framework described here.

The practical conclusion: the pecking order is a working hypothesis about where a company will go for money next time, and a reason to check whether it still has untapped debt capacity in reserve.