This lesson examines alternative theories of capital structure, focusing on the Pecking Order Theory, which challenges the notion of an optimal capital structure. It also introduces the concept of “chameleon capital” as a modern development blurring the lines between debt and equity.

• The Pecking Order Theory: This theory, first suggested by Donaldson and later popularised by Stewart C. Myers, states that firms prioritise their sources of financing based on the cost of financing and information asymmetry. There is no well-defined optimal target debt ratio; instead, the capital structure is a result of the combination of investment, financing, dividend, and market competition decisions.

• The Financing Hierarchy: The pecking order theory proposes a clear hierarchy for financing sources:

  1. Internal Funds (Retained Earnings): Firms prefer to finance investments with internal sources first, as they are the cheapest and do not involve information asymmetry.

  2. Debt: If external financing is required, firms will issue the safest security first, typically debt (starting with bank loans, then convertible bonds).

  3. New Equity: Equity is the least preferred method of raising capital and is considered a last resort. This is because equity issuance is often interpreted by investors as a signal that managers believe the firm is overvalued.

• Implications of the Pecking Order Theory: The theory explains the negative correlation between profitability and leverage—highly profitable firms with limited investment needs pay off debt and have lower leverage, while less profitable firms borrow more. It also implies that equity is an expensive and undesirable form of financing, particularly for firms in financial difficulty.

• Agency Costs and Information Asymmetry: Agency problems and asymmetric information play a significant role in shaping capital structure decisions. Managerial incentives, the risk of debt overhang, and the problem of risk-shifting are critical considerations in capital structure theory.