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Also known as the Pecking Order Model, the Pecking Order Theory is an approach to defining the capital structure of a company, as well as how the business goes about the process of making financial decisions. First developed by Nicola Majluf and Stewart C. Myers in 1984, the theory seeks to explain how companies prioritize their financing sources. The general idea is that companies will tend to take the course of least resistance, obtaining financing from sources that are readily available, and then steadily moving on to sources that may be more difficult to utilize.
While the specifics of the Pecking Order Theory are somewhat involved, the general idea can be explained by using the example of a local business entity. When it comes to financing the operation, the business is likely to make use of its internal resources first, such as using funds in a savings or other interest bearing account to manage operational costs or to order more stock or raw materials for use in the operation. When this first line of financing is exhausted or not available for some reason, the business will then turn to lenders or investors as a means of generating the funds needed to keep the company going. When no other options are available, the business may choose to make use of the equity found in any assets held by the business.
With this approach, the theory shows that the business chose to take the past of least resistance when it came to financing. Resources that were readily available were used first, since they did not involve encumbering any of the company holdings with debt. Next, the business moved on to issuing stock or a bond issue as means to raise money while still not encumbering company assets. If necessary, the business would then go for unsecured loans that left the business free to use its assets in any way deemed proper. Finally, the business resorts to financing methods that do impact company assets directly, such as trading off equity for cash or taking on a collateralized loan.
While the Pecking Order Theory holds that companies do tend to manage financing using the easiest approaches first, it does not really imply that one mode of financing is inherently superior to the other. Depending on the circumstances of a business, it may be prudent to use an asset to acquire a secured loan rather than deplete interest-bearing accounts in the possession of the business. Business owners may tend to weigh all available options and then choose the one that is most likely to produce the result that will be in the best interests of the company over the long-term, rather than simply going with what appears to be the easiest solution at present.
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