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Mini-lesson: The Pecking Order
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Myers and Majuf’s famous 1984 pecking order hypothesis attempts to
describe how firms raise capital. They hypothesize that firms are
driven by information asymmetries and transaction costs to use
internally generated capital first before turning to more expensive
sources of financing. Once their internal sources are used, then firms
will use debt (where the information asymmetry problem is less severe)
first and then as a last resort equity.
Many researchers have investigated this hypothesis. While the results
are mixed, currently the “the pecking order does not work” camp has the
momentum. For example, two current working papers have taken different
tacks, but have each come to the same basic conclusion, namely that the
pecking order hypothesis does not fit the evidence. The papers are (1)
by Fama and French and (2) by Galpin. Since I was fortunate enough to
see Galpin’s presented I will focus on it (really it has nothing to do
with the fact that he is a fellow Bonaventure alumni!).
Using several regression models, Galpin finds almost no support for the
pecking order. More importantly, he finds evidence that even shakes the
foundation of the pecking order. Namely that equity issue costs are not
always greater than debt issue costs. From 1997 to the present, equity
costs have been greater! If this was the case in the late 1990s alone I
would not have been surprised, but he reports that this relationship has
stayed the same in the years following the tech bubble. He also finds
that firms with high profits use less debt but not less equity. Which
also goes counter to existing theory.
Fama and French’s paper
http://gsbwww.uchicago.edu/fac/finance/papers/financing%20decisions%20b%202003.pdf
Galpin’s paper
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=475770
This originially appreared in the January 2004 FinanceProfessor.com newsletter
copyright 2004 FinanceProfessor.com