The Pecking Order Theory of Capital Structure: Where Do We Stand?

The Pecking Order Theory of Capital Structure: Where
Do We Stand?∗
Murray Z. Frank†, Vidhan K. Goyal‡, Tao Shen§
February 19, 2020
Abstract
The pecking order theory of corporate capital structure states that firms finance deficits
with internal resources when possible. If internal funds are inadequate, firms obtain
external debt. External equity is the last resort. Some financing patterns in the data
are consistent with pecking order: firms with moderate deficits favor debt issues; firms
with very high deficits rely much more on equity than debt. Others are not: many
equity issuing firms do not seem to have entirely used up the debt capacity; some firms
with a surplus do issue equity. The theory suggests a sharp discontinuity of financing
methods between surplus firms and deficit firms and another at the debt capacity. The
literature provides little support for the predicted threshold effects.
Keywords: pecking order, net equity issues, net debt issues, financing deficit
∗
We thank Michael Brennan, Robert Chirinko, Harry DeAngelo, Philip Dybvig, Espen Eckbo, Mark
Flannery, Paolo Fulghieri, Thomas Noe, Jay Ritter, and Jaime Zender for their helpful comments. The
usual disclaimers apply.
†
Carlson School of Management, University of Minnesota; Shanghai Advanced Institute of Finance
(SAIF), Shanghai Jiao Tong University, e-mail: murra280@umn.edu
‡
School of Business and Management, Hong Kong University of Science and Technology, e-mail:
goyal@ust.hk
§
School of Economics and Management, Tsinghua University, e-mail: shentao@sem.tsinghua.edu.cn
Electronic copy available at: https://ssrn.com/abstract=3540610

1 Introduction
Myers (1984) developed the pecking order theory of corporate capital structure to address
the puzzles created by the well-known financing irrelevance proposition of Modigliani and
Miller (1958). The pecking order has been highly influential, and it is an integral part of
the literature that attempts to find a logically coherent and empirically successful theory of
corporate financing.
Myers argues that issuing securities is subject to an adverse selection or ‘lemons’ problem.
Managers would like to use their private information to issue risky securities when they are
overpriced. Hence, when a firm announces a new issue of risky securities, rational investors,
who are at an information disadvantage, protect themselves by pricing these securities at
a discount. Managers anticipate the discounting of the risky securities and so prefer to
use securities that are immune to the lemons problem. As a result, the firm follows a
pecking order: it finances with internal resources to the extent possible. If internal funds are
inadequate, it obtains external debt – issuing risk-less debt followed by risky debt. Firms
issue equity only under duress, or when needs are so much more than internal resources that
financing with debt would produce excessive leverage.
The original development of the theory by Myers was motivated by Myers and Majluf
(1984). The original presentation was primarily verbal, and it included several features that
are not in the adverse selection model. As a result, the literature has adopted several distinct
empirical interpretations of the theory, leading to alternative testing strategies.
We begin with a definition of the firm’s flow budget constraint, and show how it relates to
the pecking order. We then present some statistics to give a sense of typical firm financing
magnitudes. Next, we discuss theoretical justifications for the pecking order and provide
an overview of particularly influential tests of the pecking order. The survey ends with our
conclusion of the present status of the pecking order.

2 The pecking order structure
2.1 Defining a firm flow budget
Consider a firm that uses real fixed assets, working capital, and internal financial resources
to produce revenue. It may be financed with debt, equity or internal resources. So cash
comes in from operations, from external financing, and from interest income on the firm’s
financial investment. Cash goes out to invest in real fixed assets and working capital, to pay
interest on debt, and dividends. The firm’s cash holding adjusts so that the flow budget
constraint is satisfied with cash-in equal to cash-out:
OP ERt + ∆Dt + pt ∆Nt + ρt−1 Casht−1 =

| {z } |{z} | {z } | {z }
Cash flow Net debt Net equity Interest received
from operations issuance issuance
Invt + ∆W orkingCapitalt + rt−1 Dt−1 + Divt + ∆Casht
|{z} | {z } | {z } |{z} | {z }
Real asset Working capital Interest paid Cash Change in
investments investments dividends cash holding
In this expression, ∆xt denote xt − xt−1 for any variable xt , where t is the date. Let ρt be
the return on cash held by the firm and rt be the return on debt owed by the firm. The
budget constraint is an identity not a theory, and it holds because of the manner in which
we define these cash flow variables.
While this presentation is straightforward from a finance perspective, it does not precisely
match standard corporate accounting because both interest expense and interest income are
part of operating cash flow in the firm’s financial statements. Therefore, we define internal
cash flow as,
CFt = OP ERt + ρt−1 Casht−1 − rt−1 Dt−1 . (1)
Using this definition, we get a standard Flow Budget Constraint,
CF + ∆Dt + pt ∆Nt = Invt + ∆W orkingCapitalt + Divt + ∆Casht . (2)

|{z}t |{z} | {z } |{z} | {z } |{z} | {z }
Internal Net debt Net equity Fixed asset Working capital Cash Change in
Cash flow issuance issuance investments investments dividends cash holding
Equation (2) is high dimensional in the sense that debt, equity, investment, working capital,
dividends, and cash holdings are all commonly regarded as firm decisions.

Define the firm’s financing needs as
N eedst ≡ Invt + ∆W orkingCapitalt + Divt + ∆Casht . (3)
The pecking order theory treats the elements of the needs as exogenous. The arrival of
investment opportunities, which depends on business conditions, is the main determinant
of investment. Working capital consists of inventory plus accounts receivable less accounts
payable. These, too, are supposed to be driven by the real business side of the firm.
Dividends are assumed to be smoothed and primarily determined by past dividends.
Evidence in support of dividend smoothing goes back to Lintner (1956). Whether it is
sufficient to treat dividends as exogenous is debatable. Treating the change in cash holdings
as exogenous is a heroic simplification. One could easily quibble with this treatment of cash
since only a part of the firm’s cash may be required for business operations. Firms often hold
cash for precautionary motives, and they could finance some or all of the deficit by drawing
down on their cash holdings. A firm with a large stock of cash holdings can use that cash
to finance itself, while a firm without much cash holdings has little room to adjust without
going to the external financial markets.
Substituting equation (3) into (2), the budget constraint can be re-expressed as,
CFt + ∆Dt + pt ∆Nt = N eedst . (4)
A financing deficit (DEFt ) can be defined as the difference between a firm’s needs (N eedst )
and its internal cash flow (CFt ). This deficit must be financed externally through issuance
of net debt (∆Dt ) and net equity (pt ∆Nt ).
DEFt ≡ N eedst − CFt = ∆Dt + pt ∆Nt . (5)
The assumptions embedded in (1) and (3) are common, but a range of other ideas can
change the definitions to some degree. As a result, various papers adopt slightly different
definitions of N eeds and CF . These alternatives are different ways of interpreting the verbal
descriptions in Myers (1984). For example, one might argue about where to draw the line

between long-term and short-term debt, and where each belongs. Investment might depend
on the cost of capital, which in turn could depend on the financing mix. One might also
be concerned about how best to treat leases, pension obligations, swaps, options, and other
derivatives issued by firms. These are important issues in their own right, and in some cases,
they might break the pecking order. Rather than exploring a lengthy list of variations, we
stick with a traditional and straightforward presentation of the pecking order.
2.2 What are real-world flow budgets like?
Myers (1984) stresses the heavy reliance on internal finance and debt. He shows that the
pecking order seems to provide a plausible account of some significant firm decisions during
1973-1982. How representative is that evidence? What is a ‘typical’ or ‘representative’ firm?
Firms differ from each other in important respects; in particular, firm size heterogeneity is
important. Large firms generally have easier access to corporate bond markets. In presenting
averages, equally (value) weighting observations will more closely reflect how small (large)
firms finance. Which is ‘representative’ ? Both are. This distinction leads to different
interpretations of how firms finance themselves, something long recognized in the capital
structure literature (see Frank and Goyal (2003), Fama and French (2005) and Fama and
French (2012)). These studies highlight the changing role of equity finance, particularly
after the 1980s. Accordingly, we update the evidence that motivated Myers (1984), but with
greater emphasis on firm size for 1971-2018.
— Table 1 about here —
Table 1 presents summary statistics regarding equation (1) for publicly traded U.S. firms
in the S&P Compustat database for 1971 to 2018. The sample excludes regulated, govern-
ment services, financial firms, and firms with missing assets. We scale the cash flow items
by lagged assets and describe them in Appendix A. Column (1) presents value-weighted
averages, while column (2) presents equally-weighted averages.
A comparison of value-weighted and equally-weighted averages of cash flow items pro-
vides a somewhat nuanced perspective on deficits and how firms are financed. Internal cash

flows are about 12.2% of lagged assets when we value-weight observations and exceed in-
vestment (10.2%) plus the change in working capital (0.9%). However, using equal-weighted
observations, internal cash flows are only 6.5% of lagged assets and exhibit a substantial
shortfall in comparison to investment (10.0%) plus the change in working capital (2.0%).
Consistent with these differences, the net equity issue is negative (-0.4% of lagged assets) for
value weight and positive (5.7% of lagged assets) for equal weight, reflecting heavy use of
equity finance by small firms. The net debt issues are comparable across the two weighting
schemes. These differences between the two weighting schemes highlight the fact that small
and large firms differ in the extent to which they rely on internal financing and debt to meet
their investment needs. Large firms can generally finance investment and working capital
internally and they issue debt to meet any shortfalls. Small firms, on the other hand, more
often need external funds, primarily equity.
Next, disaggregate N eeds into its components. For the average firm in the sample,
investment in real assets is a critical driver of its funding needs. Regardless of the weighting
scheme, the investment in fixed assets is about 10% of lagged assets, which is approximately
71% of the N eeds. Other components of N eeds are relatively minor. Investments in working
capital are roughly 1% to 2% of lagged assets. Cash dividends represent about 2.2% for value
weight and 1.0% for equal-weighted firms, reflecting the differences in payout policies between
large and small firms. The average N eeds as a fraction of lagged assets is about 14% in both
cases.
To deal with these size differences directly, we sort firms annually into three size-based
portfolios. Columns (3) to (5) of Table 1 show stark differences across the size categories.
Small firms are unprofitable with negative internal cash flows (-2% of lagged assets), while
large firms are highly profitable (11.8% of lagged assets). N eeds also differ significantly
across size categories. Large firms have a substantially higher need for funds driven by large
investments in both fixed assets and working capital. Hefty dividend payouts by large firms
also contribute to their higher needs. Large firms primarily finance these needs internally
with debt financing any deficit that remains. They issue very little equity (0.5% of lagged
assets). In short, when large firms access external capital markets, they primarily issue debt.
This is pecking order behavior. Small firms, by contrast, primarily finance through equity.

These net equity issues are significant and average about 12% of lagged assets. Small firms
also issue debt but not as much as the equity that they issue.
The bottom four rows of Table 1 present the frequency of major financing actions. Fol-
lowing a long tradition in the literature, we use a 5% threshold to determine whether an
intentional capital structure change has occurred (e.g., Hovakimian et al. (2001)). Firms
are categorized into those (a) financing internally (both net debt and equity issue < 5% of
lagged assets), (b) issuers of net debt (net debt issue ≥ 5% of lagged assets), (c) issuers of
net equity (net equity issue ≥ 5% of lagged assets), and (d) dual issuers (both net debt and
equity issue ≥ 5% of lagged assets).
Firms do not adjust financing on a large scale much of the time, but when they do, it is
more often in debt markets than in equity markets. Major net debt issues are more common
than major net equity issues for both value weight and equal weight. Looking across size
categories, we note that large firms more often rely on internal financing than small firms
do. Small firms issue both equity and debt as they have substantial financing needs and
negative internal cash flows. Large firms are relatively less likely to issue equity and more
likely to issue debt.
In summary, large firms rely significantly on internal finance to meet their needs. External
net debt issues finance the minor deficits that remain. Equity is not a significant source of
financing for large firms. By contrast, small firms lack sufficient internal resources and obtain
external finance. While much of it is equity, we also note substantial issues of debt by small
firms.
2.3 Defining the pecking order
The firm’s flow budget constraint shows how the real and the financial fit together. That
connection is definitional. The original pecking order theory relies on adverse selection, along
with several exogeneity assumptions. The endogenous variables are debt Dt and the number
of shares Nt . The standard pecking order says that there are three distinct tiers in which
the firm uses different ways to finance itself:
1. Pecking Order Tier 1. Suppose that N eedst ≤ CFt . Then ∆Dt = 0 and ∆Nt = 0.

In this case, the firm has enough internal resources to fund its needs, and it does not
need external financing. Rather, it must decide how to distribute its surpluses (i.e.,
CF over N eeds). It can pay down debt, or it can repurchase equity. Although the
usual presentations of the pecking order theory often ignore the capital distribution
problem, Myers (2003) points out that firms with surplus will work up the pecking order
when distributing money. Managers of overvalued firms will refrain from repurchasing
shares at too high a price. So, if a firm does repurchase equity, investors assume that
managers have positive information, not yet reflected in stock prices, causing prices to
rise. Given the stock price impact of attempted repurchases, firms will pay off debt
with their surpluses. Firms repurchase equity only after they have repaid all of the
outstanding debt.
2. Pecking Order Tier 2. Suppose that N eedst > CFt and N eedst ≤ CFt +DC t −Dt−1 .
Then ∆Dt = N eedst − CFt > 0, and pt ∆Nt = 0. In this case, internal cash flows are
not sufficient to meet the firm’s needs and it must close the financing deficit through
external funds. The pecking order says that debt is used if possible. Debt will be
adequate to close the gap as long as the debt capacity (DC t ) does not bind. Debt can
never exceed capacity, so Dt ≤ DC t , or ∆Dt ≤ DC t − Dt−1 . In this tier, the debt
capacity does not bind and no equity is issued.
3. Pecking Order Tier 3. Suppose that N eedst > CFt + DC t − Dt−1 . Then Dt = DC t
and pt ∆Nt = N eedst − CFt − DC t + Dt−1 > 0. Since the debt capacity is binding,
the firm will set Dt = DC t , and equity issues, pt ∆Nt , must make up the balance
of the necessary funding. Thus, the final rung of the pecking order says, pt ∆Nt =
N eedst − CFt − DC t + Dt−1 . The firm uses internal resources plus the full debt
capacity plus some new external equity to fund itself.
The pecking order does not specify how many firms are in each tier. So the theory
pertains to individual firms and is silent about the aggregate. The literature often implicitly
assumes that all or at least most firms are in Tier 2 (e.g., Frank and Goyal (2003)).
Over many decades, both the corporate sector as a whole and even most individual firms
have not drifted to a corner with just a single type of financing. In the aggregate, there is a

fair degree of long-run stability of capital structure across many decades and many countries
as documented by Frank and Goyal (2008) and Graham et al. (2015). At the firm level,
however, there is much less stability as shown by DeAngelo and Roll (2015). These facts do
not readily emerge from the traditional pecking order theory.
If a firm issues debt or sells new shares in the market, its leverage ratio would change.
The market price of its shares will reflect these security issuing decisions. If firms follow
the pecking order, then there may be new asset pricing implications from the nature of the
time-varying leverage and investments. To the best of our knowledge, no study explores this
issue carefully.
There are, however, short-run event studies that examine the market reaction to security
issues. Debt issues generally have little effect on share prices, whereas common share issues
are associated with share price drops (e.g., Eckbo et al. (2008)). While one could conclude
that the fall in share price upon the announcement of a new issue is consistent with the
pecking order theory, the interpretations are not entirely straightforward. Depending on the
issuing motivation and terms, the new equity issue could increase or reduce the value of the
pre-existing shares. If share prices drop when equity is issued, then the information that the
market has about the firm may have changed, the terms of the issue may not have been fair,
or the market may not be strictly efficient. Any connection to the pecking order is a loose
one.
3 Pecking order statistics
3.1 Financing actions by surplus and deficit firms
It is natural to ask whether the cash flow budgets of firms conform to the predictions of the
tiers suggested by the theory. We sort firms into three portfolios based on whether they have
a surplus or a deficit. Firms are generating surpluses if CF exceeds N eeds by more than 5%
of lagged assets. Firms are in balance when N eeds − CF is within ± 5% of lagged assets.
Finally, firms are generating deficits when N eeds exceeds CF by more than 5% of lagged
assets. Firms with surpluses and those in balance are in pecking order Tier 1, whereas firms

with deficits are in pecking order Tiers 2 and 3. Table 2 presents the results.
About 15% of firm-year observations are in the surplus group. Surpluses arise for various
reasons. Low investment needs (3.1% of lagged assets) and minimal dividend payouts (0.8%
of lagged assets) reduce the needs. At the same time, these firms reduce working capital (-
1.9% of lagged assets) and deplete cash holdings (-0.8% of lagged assets), leading to surpluses.
These firms also exhibit high levels of internal cash flows (11.6% of lagged assets). In
summary, low investment needs and high profitability coupled with reductions in working
capital and depletion of cash holdings lead to large surpluses.
Firms use surpluses to both pay down debt and to repurchase equity. The net debt issues
are -8.1% of lagged assets, while the net equity issues are -2.3% of lagged assets. The fact
that firms primarily use surpluses to pay off debt may suggest that firms care about building
debt capacity for future financing. The pecking order theory, however, makes a stronger
prediction. According to Myers (2003), firms should repurchase equity only after they have
paid down their debt. But in reality, firms often repurchase equity while they still have
significant debt remaining on their balance sheet. Non-pecking order motives for capital
distribution policies appear to be at work.
About 56% of firm-year observations are in the balance group, as shown in column (2).
These firms generate internal cash flows (8.8% of lagged assets), which are just about enough
to meet their investment and dividend needs (8.5% of assets). Predictably, these firms are
the least active in external financial markets. They issue debt, which is just enough to meet
their debt repayments. They are relatively inactive in equity markets, with both issuances
and repurchases being close to zero. Firms in this group maintain net financing close to zero.
About 29% of firm-year observations are in the deficit group. These firms have significant
investment needs (19.8% of lagged assets) and large working capital requirements (5.8% of
lagged assets). Their deficits increase further because of build up of cash holdings (4.8% of
lagged assets). Importantly, these firms are not profitable, and their internal cash flows are
about zero (-0.4% of lagged assets). Thus, deficits arise because of a combination of negative
profitability and significant investments in both real and financial assets. Firms finance these
10

deficits in external capital markets: net debt issuances of about 11.3% of lagged assets and
net equity issuances of approximately 20.3% of lagged assets.
Even firms generating deficits often pay dividends, roughly comparable to those paid by
surplus-generating firms. That is surprising given the significant need for funds for invest-
ment and the necessity of raising capital. Deficit firms repurchase little equity, so much of
their equity issuances are to cover their deficits, including financing of dividend payouts.
Farre-Mensa et al. (2014) discuss various reasons for financed payouts, including a desire to
manage capital structure and cash holdings, monitoring managers, and engaging in market
timing. While the firms generating deficits raise funds more through debt than through
equity, the net issues of debt are smaller than equity because firms must repay some debt
due to its fixed maturity.
In summary, firms generating surpluses return money to both debt and equity holders.
For self-sufficient firms, their issuance activities on the debt side are just large enough to
offset their debt repayments. These firms are not very active in equity markets. Firms
generating deficits (because of lack of profitability and large investment needs) access both
debt and equity markets. The average firm issues more equity than debt. However, a focus
on major financing decisions reveals a higher propensity to make major net debt issues rather
than major net equity issues.
3.2 Financing actions by deficit size
According to the pecking order theory, firms generating deficits will issue debt if they have
not reached their debt capacity and turn to equity if they have. However, it is not clear
whether firms with deficits (as in column (3) of Table 2) have reached their debt capacity.
The notion of debt capacity is theoretically ambiguous. If the debt capacity is simply the
optimal debt level from the firm’s perspective or an outcome of market equilibrium, it may
not be a feasibility constraint at all. If the debt capacity reflects the costs and benefits of
optimal debt, the distinction between the pecking order and a conventional trade-off theory
is ambiguous.
No entirely satisfactory resolution is available in the literature. Lemmon and Zender
(2010), for example, use several conventional firm attributes to estimate a firm’s probability
11

of having a debt rating and apply this probability as a proxy for the debt capacity. Since the
firm attributes that determine ratings are similar to those that affect leverage, one wonders
whether firms with debt capacity are also those operating below their target leverage. Then,
how do we distinguish pecking order predictions from those due to forces like debt overhang.
Leary and Roberts (2010) use the data to see if they can infer debt capacity from the observed
decisions in a manner that then justifies the pecking order. No sharply defined debt capacity
emerges.
Instead of relying on an ad hoc proxy, we sort firms with positive deficits into three
portfolios based on the size of the deficit and report results in Table 3. Presumably, firms
with high deficits are more likely to have used up their debt capacity to meet their financing
needs, so they tend to be in Tier 3. The debt capacity for firms with low deficits is less likely
to be binding, so these firms tend to be in Tier 2.
In column (1) of Table 3, firms with low deficits have N eeds, of about 15.2% of lagged
assets. These are almost twice as large as the internal cash flow. The resulting deficit of 7.7%
of lagged assets is financed through both debt and equity, with net debt issues contributing
5.4% and equity contributing 2.3%. Firms in this tier primarily finance with debt (about
73% of these firms have net debt issues exceeding 5% of lagged assets). Many firms in the
low deficit group are also active in equity markets, with about 20% of them issuing net equity
over 5% of lagged assets. Equity issues by these firms are surprising from the perspective
of the pecking order theory if firms in the lowest tercile of deficit are those with ample debt
capacity.
For firms with medium deficits, both debt and equity once again finance the deficit of 18%
of lagged assets, with net debt issues contributing 10.7%, and net equity issues contributing
7.3%. All of the firms in the medium deficit group make major interventions in capital
markets, with 65.6% of firms completing a major debt issue, 25.8% completing a major
equity issue, and 8.6% issuing both major net debt and net equity.
Firms with high deficits, by construction, require massive interventions in external capital
markets. The large deficits arise primarily due to large investments (31% of lagged assets),
12

net working capital of (10% of lagged assets), and build-up of cash holdings (14.4% of lagged
assets). This cash accumulation in the face of high real investment needs and negative
profitability is striking. The critical question is: how are the large deficits funded? Unlike
other groups, the high deficit firms rely much more on equity than they do on debt. The net
debt issues are significant (17.8% of lagged assets), but the net equity issues are remarkably
large (51.2% of lagged assets). In terms of major financing decisions, about 44% of firms
in this group issue net equity over 5%. The patterns reported here are consistent with the
evidence in Denis and McKeon (2018) and Huang and Ritter (2019) who show that firms
with persistent cash needs issue equity and save much of it in cash. Firms accumulate cash
to prepare for future financing needs and to relax future financing constraints. Furthermore,
Denis and McKeon show that firms financing their persistent losses with equity are high-
growth firms with low leverage and high investment in intangibles.
The evidence that 32% of high deficit firms issue primarily debt and 24% issue both
debt and equity is surprising from the perspective of the pecking order theory. Eckbo and
Kisser (2018) also find that firms often finance capital-intensive investment through debt
issues. Within the pecking order, this should mean that even high deficit firms have not
reached their debt capacity, so they issue debt. Alternatively, it could mean that other
considerations guide financing choices so that firms issue both debt and equity to stay in
balance. Or perhaps they are concerned about other frictions.
The sorting into terciles does not give us enough granularity. Figure 1, therefore, plots
results from sorting firms into 100 equal-sized bins based on their financing deficits. We plot
the average net debt issue and net equity issue for firms in each bin. The dashed vertical
line is the point of balance where the deficits are zero. The bins to the left (right) are firms
with surpluses (deficits). The upper figure presents the financing decisions of all firms in the
sample. While it is useful to examine firms at the extremes, it is also instructive to examine
firms in the middle. The lower figure, therefore, focuses on firms in the middle between the
30th and the 60th percentile of financing deficits.
— Figure 1 about here —
In the upper figure, note the asymmetry - the surpluses are never as large as the deficits.
13

This may reflect the possibility that some of the items in N eeds are not entirely exogenous.
Thus, surpluses never get very large because firms increase investments, dividends, or cash
holdings as they experience high internal cash flows. When firms distribute these surpluses,
distributions are to both debtholders and stockholders, with debt repayments dominating
equity repurchases over the entire range of surpluses. Equity repurchases increase with
surpluses, but their magnitudes are consistently smaller than debt repayments.
Turning to the deficits on the right of the dashed vertical line, we note that both debt
and equity issues increase with deficit until we reach levels that are in the 90th percentile. At
that point, we observe a very sharp increase in equity issuances and a drop in debt issuances.
Overall, the figure suggests that firms are relatively more active in debt markets as long as
the deficits are reasonable. They turn to equity markets when deficits become massive.
The lower figure shows an apparent lack of discontinuity in financing choices as we move
from surplus firms on the left of the dashed vertical line to those with deficits on the right.
Firms with small surpluses often issue small amounts of equity. Surprisingly, even firms
with small deficits issue some equity. As deficits increase, net debt issues eventually become
larger. But this sequence of financing does not seem to reflect pecking order considerations.
The fact that firms do issue or repay equity in small amounts has been stressed by Fama
and French (2005) as being problematic for the pecking order. It also raises questions about
the commonly used 5% threshold as a measure of material external financing.
3.3 Which firms do nothing?
Some firms do nothing to adjust leverage. To understand how these firms fit into the theory,
start with firms that have a deficit of zero or ∆Dt + pt ∆Nt = 0 as in equation (5). Without
further theoretical assumptions, the adding up constraint does not place limitations on either
net debt or net equity. According to the pecking order, firms should take no financing actions
when deficits are zero, so ∆Dt = pt ∆Nt = 0. Furthermore, small surpluses should lead to
repurchase of debt, so ∆Dt < 0 and pt ∆Nt = 0, while small deficits should lead to issue of
debt, so ∆Dt > 0 and pt ∆Nt = 0. Therefore, there should be a point of discontinuity for
debt issuance when the deficit is zero. Equity change should be zero for an extensive range
that starts where the debt is entirely paid off (surplus) and continues to the point at which
14

the debt capacity is reached (deficit).
We examine the financing actions around the zero deficit point in Figure 2. As in Figure
1, we sort firms into 100 bins, and for each bin, Figure 2 shows: 1) the fraction of firms
with precisely zero change in the debt over the year, and 2) the fraction of firms that have
precisely zero change in the number of shares outstanding over the year.
— Figure 2 about here —
The zone of elevated inaction does exist in a rather narrow band between about bins 43
and 53. That is roughly from a financing surplus of around 2% to a deficit of about 0.03%.
At the point of zero deficit, about 50% of the firm-year observations have zero change in debt,
and approximately 60% have zero change in the number of shares outstanding. This finding
does not support the pecking order theory. The debt capacity would have to be reached at
group 53, which is below the range at which most debt is issued. Figure 1 suggests that the
debt capacity is at roughly bin 90.
Roughly half of the firm-year observations have non-zero financing actions when the
deficit is zero. Because ∆Dt + pt ∆Nt = 0, it means that firms take offsetting financing
actions. For firms with small surpluses (deficits), about 80% (90%) of them have changes in
the number of shares outstanding. Again, this does not accord well with the pecking order
prediction.
Note that in trade-off models (e.g., Fischer et al. (1989), Goldstein et al. (2001), Frank
and Goyal (2015)), fixed cost of leverage adjustment implies that there exists a zone over
which firms make no active leverage adjustments. Leverage simply drifts as a reflection of
the changes in the market value of equity. If firms in the inaction zone in Figure 2 also
happen to be away from their optimal leverage, then this feature of the data is consistent
with the fixed cost adjustment in the trade-off models. But again, the zone of inaction seems
rather narrow.
3.4 Which firms undertake major financing actions?
How much do financing deficits drive the observed financing actions of firms? We examine
the distribution of firms across deficit categories for firms financing internally and for those
15

raising external finance in the form of major debt issues, major equity issues, and dual issues
(firms issuing both debt and equity). Table 4 shows that of the firms financing internally,
most are in balance (78%) or generating a surplus (21% of firms). The pecking order does
not predict that these firms should issue either debt or equity because the internal cash flows
are either about equal to their needs or exceed them. Among the firms financing internally,
few are generating a deficit but this deficit is smaller than the threshold at which we start
tracking debt and equity issues.
Debt issuers are typically firms with deficits. However, most of these are by firms that
have low or medium deficits. Firms in the highest tercile of deficits more often fund their
deficits with equity than they do with debt. Dual issuers are all concentrated among deficit-
generating firms. Dual issues become more common among higher deficit terciles.
In summary, firms generating surpluses generally do limited external fundraising. Firms
roughly balanced between cash needs and internal cash flow commonly undertake rather
small amounts of debt and equity issuing. They more often issue equity than debt. Firms
with deficits are active in both debt and equity markets. As deficits increase, the likelihood
of major net debt issues falls while the possibility of major net equity issues rises.
4 Theory
The original justification for the pecking order is adverse selection.Myers and Majluf (1984)
developed the adverse selection theory of financing, and Myers (1984) combined it with
additional ideas into the pecking order. We first discuss the adverse selection models following
Cadsby et al. (1990). Bolton et al. (2005) and Tirole (2010) provide good textbook versions
of the theory. We also discuss how pecking order financing can arise even in the absence of
adverse selection.
Some financial economists choose to interpret the pecking order theories rather literally.
They generally point to the evidence that is either consistent or inconsistent with a range
of implications of the theory. Other scholars think of the pecking order as an interesting
16

parable that may help provide insight. Such scholars are generally much less interested in
tests of the literal empirical implications of the theory. Which features of the theory appear
more relevant often depend on tastes.
4.1 Adverse Selection
A firm is run by managers who know the true value of the firm’s assets and a profitable new
project (‘growth opportunity’). Outside investors can only guess.
The firm is equity-financed and has assets in place Ai and a positive NPV project that
pays off Bi where i is either high (H) or low (L). So AH + BH > AL + BL , and nature
determines that the two types are equally likely. To undertake the project requires an equity
investment of I that must come from outside investors, or else the opportunity will be lost.
If the project happens, the value of the firm will be Vi = Ai + Bi + I. But it must be
shared between the original owners who will get (1 − s)Vi and the new equity investors who
will get sVi . Will it pay for the manager to undertake the project or to let it go? That
depends on s. The value of s depends on what the investors believe since they must expect
to at least break even. If I < sVi the investors gained, and if I > sVi the investors lost
money. Investor competition implies I = E(sVi ), where E(·) is the expectation operator.
In general, there can be a pooling equilibrium, a separating equilibrium, or a semi-
separating equilibrium. In a pooling equilibrium, both types of firms undertake the project.
1 1
In that case, the investor knows that there is a 2
chance that the firm is of type L and a 2
chance that the firm is of type H.

In a separating equilibrium, only the type L undertakes the project. Accordingly, the
investor knows that the firm raising the equity is of type L, and prices the investment,
s∗ = I/VL . Investors treat any firm issuing equity as type L. The type H firm prefers to
forgo the new project because it does not get enough from the project to overcome the cost
of losing a significant fraction of the current value by being treated as the type L.
Can this separating equilibrium happen? The answer provided by Myers and Majluf
(1984) is yes for some parameter values, and it has important implications for the pecking
order. Self-financing would be attractive because it completely avoids the guessing game
and potential adverse selection problem. That is the first tier in the pecking order hierarchy.
17

If the debt is risk-free, then there is no adverse selection, and it is just as good as internal
funding. Many papers assume that firms only issue safe debt. Or, that it is limited by
the value of the firm’s collateral as in Hennessy and Whited (2005). These are convenient
simplifications for theoretical analysis. But empirically, many firms do, of course, issue risky
debt. The adverse selection cost for risky debt is not as large as that for equity; hence firms
choose risky debt over equity. Myers (1984) suggests that risky debt is somewhere between
pure self-financing and equity finance and constitutes the second tier of the pecking order
hierarchy.
Risky debt is conceptually complex. Although Myers and Majluf (1984) consider financ-
ing with risky debt, neither Myers (1984) nor Myers and Majluf (1984) clearly define debt
capacity for risky debt. Lemmon and Zender (2019) extend the model of Myers and Majluf
(1984) by considering debt covenants. Debt covenants allow the lender to liquidate the firm
in certain scenarios, but the liquidation is costly because of the inferior information of the
lender. The liquidation value becomes a measure of the firm’s debt capacity in the sense that
at that point, the entrepreneur has no motivation to issue debt in response to the adverse
selection problem. The optimal level of debt in the model may be below the firm’s debt
capacity, depending on assumptions about the renegotiation of covenants.
We could adopt the ‘natural debt limit’ from macroeconomics (e.g., Ljungqvist and Sar-
gent (2018)), which is determined by the maximum amount that a firm can repay if it uses
all future cash flows to make payments on debt. This debt capacity would be a feasibility
constraint. But incentive issues probably matter. Tighter limits might reflect sequential in-
centives actually to service the debt. Whether such sequential incentives would help produce
pecking order behavior is likely to depend on detailed assumptions. Outside equity is not an
equilibrium security. It is issued once the firm has reached its debt capacity. That defines
the third tier of the pecking order hierarchy.
It is essential to recognize that even the retained earnings part of the pecking order may
not be as simple as it sounds. The claim that self-financing completely avoids the information
problems might be wrong. Tirole (2010) observes that the manager still needs to convince
investors not to demand their money back. While such a demand may sound unusual, it
can happen directly through investor activism. For example, in the 1990s, Kirk Kerkorian,
18

Chrysler’s largest shareholder, famously demanded that the company disgorge its substantial
cash holdings to its investors (Marcum et al. (2011)). Dealing with such a demand can raise
similar adverse selection problems as raising external equity. In both cases, management
must convince an outside investor about claims on the firm, and management presumably
has better information. So retained earnings may not always be so free of informational
issues.
With both risky debt and equity being issued, there is often scope for many equilibria,
and there is no clear basis for selecting amongst them. Pecking order may or may not emerge
from the theory - details matter, including equilibrium selection. The standard analysis of
this issue is provided by Noe (1988). Cadsby et al. (1998) provide experimental tests of the
underlying theory, as well as tests of equilibrium selection. They find that learning and path
dependence seem important. The standard equilibrium selection criteria seem less helpful.
Several papers show that adverse selection problem can be solved by certain financing
strategies (Brennan and Kraus (1987), Constantinides and Grundy (1989), Chakraborty
and Yilmaz (2011)) or properly designed managerial contracts (Dybvig and Zender (1991),
Baranchuk et al. (2010)) and can even disappear in dynamic models (Morellec and Schürhoff
(2011)).
Recent theoretical work has shown that adverse selection does not necessarily lead to
pecking order behavior. The pecking order is obtained only under special conditions, as in
Nachman and Noe (1994).
An important point is whether the information asymmetry is about assets in place or
about growth opportunities. The pecking order, as in Myers and Majluf (1984), arises
when the information asymmetry is about the assets in place. Both assets in place and
growth opportunities are distinct, and each could have a high degree of private information.
Myers (2015) emphasizes that pecking order should apply to mature firms and not to growth
firms since ‘it’s mostly managers’ inside information about assets in place that blocks equity
issues and investment’. While it is true that mature firms often have relatively more assets
in place than growth opportunities, it is unclear if information asymmetries overall are more
significant for mature firms. More information has accumulated about the assets in place for
mature firms. Small, young firms are more likely to have greater information asymmetries
19

about all of their assets because of their short history.
A more subtle perspective on how asymmetric information affects the use of debt and
equity is Fulghieri et al. (Forthcoming). Here, the relative mispricing of debt and equity
depends on the comparative exposures to the firm’s assets in place, growth options, and
their volatilities. The emphasis on the relative volatility is an interesting contribution of this
paper. Growth options are risky, but perhaps less exposed to asymmetric information than
are the assets in place. As a result, there can even be a reversal of the traditional pecking
order. In their model, violation of the usual pecking order is particularly likely for small
firms, which is what we observe. This paper contributes to the growing recognition that
adverse selection does not automatically imply the usual pecking order.
Halov and Heider (2011) point out that since debt is a concave claim, investors who are
uninformed about risk could misprice it. Since the firm must issue those securities that are
likely to be least mispriced by imperfectly informed investors, they will sometimes avoid
issuing debt. This could happen if the odds of default are significant, and debt issues can
create information problems. The adverse selection cost matters most for small, young, and
non-dividend paying firms as the outside market knows less about their risk. Hence, it is
not surprising that these firms issue equity even though they have not exhausted their debt
capacity.
Recently there is an interest in how ambiguity aversion might affect corporate finance
(see, Izhakian et al. (2016), and Malenko and Tsoy (2019)). The basic idea is that investors
believe that many things can happen, and they focus particularly on the worst path when
valuing assets. If outsiders think that the worst path is worse than what the insiders know,
then they will undervalue that security relative to what insiders know even if everyone has
the same beliefs about the expected values. Under ambiguity aversion, large uncertainty
can be quite different from small uncertainty. Malenko and Tsoy (2019) find that in the
presence of ambiguity aversion and private information about a new project, for sufficiently
large uncertainty, equity finance is used. For sufficiently low uncertainty, there is risky debt
but no equity. Much like the standard adverse selection pecking order, if there is private
information about assets in place, equity is avoided, and the firm will generally use debt
financing.
20

Not all discrete financing region theories are pecking order theories because they may not
have the standard tier structure. For example, Frank and Sanati (2019) study a model based
on tax and collateral considerations. In that model, firms initially issue equity for investment
purposes, and later, they issue debt and repurchase the equity once the investment is in
operation. That generates discrete financing behaviors, but it need not match the traditional
pecking order predictions regarding the three Tiers.
Bharath et al. (2008) evaluate the core assumption of information asymmetry for the
pecking order theory. They construct several market microstructure asymmetry proxies and
test if firms with more asymmetry use more debt finance. The asymmetry is time-varying
so the pecking order might be more applicable at some times than it is at other times. If
this is right, then there may be significant interactions with the market timing perspective
(e.g., Baker and Wurgler (2002)), which have not yet been studied.
4.2 Other Justifications
4.2.1 Taxes
The first distortion introduced into the Modigliani and Miller theorem was the tax-deductibility
of interest payments in Modigliani and Miller (1963). They do not distinguish between in-
ternal and external financing. All finance is external. They concluded that firms should be
100% debt-financed to exploit the tax advantage fully. However, if we introduce a ‘debt ca-
pacity’ limit somewhere below 100%, then the firm might first completely use that capacity
to issue debt. But if that does not raise enough money, it would turn to external equity. A
pecking order might quickly emerge in such a model.
Stiglitz (1973) highlights the internal versus external financing distinction. There is a
fundamental asymmetry in the tax code. If an investor gives money to a firm, the investor
does not pay a tax. If a firm returns money to an investor, the investor does pay a tax. The
amount of tax paid depends on whether the investor is providing debt or equity to the firm.
As a debt holder, the investor pays taxes on interest income, historically more heavily taxed
than capital gains from equity. As a shareholder, the investor pays taxes on dividends and
capital gain. Once funds are inside the firm, there is a tax incentive to leave them inside the
21

firm even though firm profits are taxable at the corporate rate. Stiglitz (1973) observes that
if the personal tax rate exceeds the corporate rate, it pays to finance as much investment as
possible through retained earnings. Whether excess of investment beyond retained earnings
is funded by equity or debt depends on their after-tax return to investors. The observed
leverage ratio is a ‘fortuitous outcome of the profit and investment history of the firm.’ In
other words, tax considerations may generate some firm decisions that are quite similar to
the usual pecking order.
4.2.2 Agency
The claim that managers prefer internal financing to external financing is much older than
the pecking order. Butters (1949) suggests that many executives naturally think of internal
funds as low cost. A variety of factors appear to be responsible, including what we would
call agency considerations and what we would call behavioral factors.
Myers (2003) points out that the agency conflicts in Jensen and Meckling (1976) can
generate a pecking order. An entrepreneur who self finances the firm’s investment has no
distortions. Both the marginal cost and the marginal benefit of the investment have their
full impact on the entrepreneur’s wealth. So self-financing is undistorted. If debt is risk-free,
then the investor still obtains the full marginal benefit of investing. So outside debt is just
as good as self-financing. But outside equity is different. The entrepreneur pays the full cost
of effort but shares the benefit of the effort with the outside investor. In this sense, equity
is less desirable.
This underinvestment is inefficient. The use of internal financing would result in higher
welfare. Thus, retained earnings are preferred. Debt is just as good in this simple model.
Equity is inefficient. Hence, we have a version of the pecking order. If debt is relatively safe
but not entirely risk-free, then it is easy to imagine an ordinary pecking order with the three
distinct categories that could emerge.
The agency conflicts can give rise to the pecking order behavior through other channels.
For example, managers have incentives to meet earnings per share (EPS) targets because of
their compensation schemes. When the expected returns on investments are low, managers
are reluctant to issue equity, which can potentially dilute EPS. In this case, debt financing
22

is preferred. Brennan and Kraft (2018) find empirically consistent evidence that managers
rely more on debt financing when earnings prospects are poor.
Lambrecht and Myers (2012) study a dynamic agency model in which managers attempt-
ing to maximize the rents they take from the firm make payout, investment, and financing
decisions. Their model rationalizes the target payout model in Lintner (1956). In particular,
they focus on the capital budget constraint, ∆Debt + N etIncome = CAP EX + P ayout.
Investment opportunities determine CAP EX, and the payout is smooth, so the change in
debt, ∆Debt, must soak up most of the shocks in net income. Because debt serves to ab-
sorb fluctuations in operating profitability and capital investment, it follows a pecking order.
Note that the aim of the agency issue is not to generate a pecking order of debt. It is the
consequence of the payout smoothing due to the rent smoothing.
4.2.3 Behavioral
Heaton (2002) studies a model of corporate finance with overly optimistic managers and
efficient capital markets. Optimistic managers believe that the capital market undervalues
the firm, and hence they view external financing to be unduly costly. Hence, optimistic
managers use internal cash and risk-free debt first and prefer risky debt to all equity financing.
It is challenging, however, to measure managerial optimism. Malmendier and Tate (2005)
and Malmendier et al. (2011) construct measures of CEO overconfidence. They argue that an
overconfident CEO will regard outside funds as too expensive, and it mainly affects external
equity. So a pecking order might quickly emerge.
Alternatively, perhaps the pecking order is a simple heuristic that economizes on decision
making. Malmendier et al. (2011) may be understood as reflecting heuristic decision making
where the heuristics reflect CEO experiences. A CEO who adopts a suboptimal approach
on her account often seems to take a similar (suboptimal) approach for the firm decisions.
Gigerenzer and Gaissmaier (2011) provide a helpful review of the literature about the role
of heuristics.
Other behavioral biases can also generate non-pecking order decisions. Hackbarth (2008)
compares managers with biased growth perceptions to managers with biased risk perceptions.
In one case, a pecking order emerges, and in the other case, a reverse pecking order is
23

predicted. So the exact nature of the bias is essential.
4.2.4 Other mechanisms
A number of studies including Altinkilic and Hansen (2000), Leary and Roberts (2010) and
Fama and French (2012) suggest that transaction costs can also generate pecking order
behavior. For example, pecking order could be a result of issuing costs that are zero for
retained earnings, low for short-term debt, and the highest for share issues.
Anderson and Carverhill (2011) study a model of dynamic cash holdings and show that
the optimal cash policy leads to a financing hierarchy that depends on the business con-
ditions. The standard pecking order holds if the business conditions are right. When the
business conditions are adverse, firms prefer equity issues to the short-term debt if internal
funds are not available. This finding suggests that in a dynamic pecking order framework,
firms make debt choices after considering the costs of issuing securities over time. Firms
expecting significant investments in the future would preserve debt capacity.
5 Key tests
5.1 The Shyam-Sunder and Myers (1999) test
An influential approach to testing the pecking order was developed by Shyam-Sunder and
Myers (1999) (SSM test). They study 157 firms that have continuous data from 1971 to
1989. The SSM test is a regression
∆Dit = a + bP O DEFit + eit . (6)
The key prediction is βP O = 1, so Shyam-Sunder and Myers (1999) essentially assume

that firms are all in Tier 2. They estimate βP O = 0.85, which is reasonably close to 1, al-
beit statistically significantly lower. This striking empirical evidence generated considerable
interest and effort to understand how best to interpret the results.
In a broader population of firms with a more extended sample period, Frank and Goyal
(2003) find that βP O = 0.28 and that empirically large firms behave more like the pecking
24

order. It suggests that the sample of the SSM test may not be a good reflection of the broad
population of firms. Their finding also raises the issue of the interpretation of the firm size
effect. It is not clear whether the pecking order theory applies more strongly to small firms
or large ones. Smaller firms typically receive much less news media attention and analyst
coverage, so the insiders often have an informational advantage when compared to otherwise
similar large firms. Larger firms are commonly thought to be slower growing and may have
more of their value in the form of assets–in–place rather than growth options. Asset–in–
place may be more subject to adverse selection when compared to growth options. Hence in
principle, the firm size implications can go either way, depending on what control variables
are included and which force is more important. Frank and Goyal (2003) and Fama and
French (2005) argue that the asymmetric information problems are more serious for small
firms than large firms, so the evidence that large firms behave more like the pecking order is
against the theory. Myers (2015) sharply criticizes this idea. A helpful clarification of these
issues is provided by Fulghieri et al. (Forthcoming).
Section 4 suggests that a pecking order could be due to adverse selection, agency conflicts,
and perhaps other forces. The SSM test does not provide identification of an underlying
theoretical justification for a pecking order. Even if an SSM test were to substantiate a
pecking order, it would still be entirely silent about the underlying driving force.
Does the SSM test correctly identify parameters of interest within the pecking order
theory? Not necessarily. Chirinko and Singha (2000) provide examples that call into question
the interpretation of the SSM test. In one case, the pecking order is true, but the SSM test
would reject it. In another, the pecking order is false, but the SSM test would not reject it.
This is disconcerting.
Some of the problems with the SSM test are easy to see. Suppose that the pecking order
is true. Even then the theory does not tell us how to define the debt capacity. So we do not
know for sure which tier any firm belongs to. In Tiers 1 and 3, the theory predicts bP O = 0.
In Tier 2, the pecking order predicts bP O = 1. As outside observers, we do not know how
many firms in our data belong to each tier. A population regression will yield a weighted
average of the firms with a coefficient of 0 and a coefficient of 1. The estimated coefficient
would say something about how many firms are in Tier 2 relative to the overall population
25

of firms. It does not say anything clear cut about the merits of the pecking order relative to
other theories. Estimates of bP O are probably best regarded as simple descriptive statistics
rather than as structural parameters that test any particular theory.
The SSM test has been an influential testing method in the literature. However, by
now, a variety of drawbacks to the method have been convincingly established. Accordingly,
without modifications, this is probably no longer a suitable method for testing the pecking
order against alternative theories of capital structure.
5.2 The Fama and French (2002) test
Fama and French (2002) link the dividend payout and leverage with various firm charac-
teristics through three sets of regression models: 1) a target dividend payout model, 2) a
dividend partial adjustment model, and 3) a leverage partial adjustment model. They inves-
tigate whether the coefficients of various firm characteristics are consistent with the trade-off
and pecking order predictions.
Fama and French (2002) argue that more profitable firms and firms with fewer invest-
ments should have higher dividend payouts under the pecking order theory, and the evidence
supports this prediction. They also find positive relations between leverage and firm size,
and between dividend payout and size and argue that these results can be consistent with
the pecking order theory.
According to the pecking order, more profitable firms have more internal resources, and
those internal resources pay for investments and then pay off debt. As a result, firms will
have less leverage. Fama and French (2002) provide support for this idea, and a number
of studies find similar evidence, see Bradley et al. (1984), Harris and Raviv (1991), Rajan
and Zingales (1995), Frank and Goyal (2009), and Eckbo and Kisser (2019). The negative
correlation between profitability and leverage is the single most cited fact in support of the
pecking order theory. Recently, Frank and Goyal (2015) show that the negative relation is
a consequence of adjustment costs. Firms respond to profitability shocks by adjusting their
debt - however, the response is not large enough to offset the mechanical change in equity.
Hence leverage ratios decline even though higher profitability results in a response in debt
markets consistent with alternative theories.
26

According to the pecking order, firms do not have leverage targets, so the estimated
speed of adjustment should be indistinguishable from zero. Fama and French (2002) find
statistically reliable evidence that the speed is positive, but its magnitude is suspiciously
small. Flannery and Rangan (2006) and Faulkender et al. (2012) find similar evidence.
However, the structural interpretation of adjustment speed is subject to the debate, see Leary
and Roberts (2005), Huang and Ritter (2009), Chang and Dasgupta (2009), Hovakimian and
Li (2010), and Elsas and Florysiak (2015)). Furthermore, Frank and Shen (2019) show that
mismeasured targets seem to have biased the estimated speed coefficient towards zero. When
firm-specific time-series models are estimated, much faster speeds of adjustment are observed.
Consistently, DeAngelo and Roll (2015) find that time-varying leverage targets could best
explain the observed leverage dynamics.
Fama and French (2002) also show that there is significant equity issuing by small low-
leverage growth firms. Related evidence is visible in Table 1. It seems clear that there
is much more common use of equity financing in recent decades in contrast to the data
that motivated Myers (1984). To see whether this contradicts the pecking order requires
identifying which of the three Tiers each firm-year belongs to. This idea leads naturally to
the tests by Leary and Roberts (2010).
5.3 The Leary and Roberts (2010) test
SSM test does not adequately reflect the hierarchical structure of the theory. Leary and
Roberts (2010) explicitly adjust for the hierarchical structure of the pecking order. Because
the pecking order does not precisely define the locations of the thresholds, they try a variety of
empirical proxies for the threshold locations. They also consider both a strict interpretation
of the theory along with more liberal interpretations in which various adjustments take into
account other considerations.
Leary and Roberts (2010) report that 67% of financing uses internal funds, 23% uses debt,
and the rest uses equity. The dominance of internal funding is as expected in a pecking order.
They also find that equity finance is particularly important for smaller and younger firms.
In a more liberal interpretation of the pecking order theory, Leary and Roberts (2010)
find that pecking order correctly predicts 74% of the internal-external financing splits, 30%
27

of the debt-equity splits, and 0%, i.e., none, of the equity issuance decisions. Almost 39%
of the debt issues violate the pecking order because they are undertaken even when internal
funds exceed investment.
An innovation of Leary and Roberts (2010) is that they exploit the data directly to infer
a set of implied thresholds for internal funding and for inferring debt capacity. The results
in their paper suggest that 60% of the equity issues take place when the firms still had
adequate debt capacity. For this to be reasonable, firms would have to be remarkably debt-
averse beyond what can be justified by considerations of the remaining investment grade.
They examine which friction(s) generates pecking order behavior and employ several
proxies for information asymmetry. However, they find no robust support for firms of high
information asymmetry adhering more to the financing hierarchy. Instead, when they stratify
the sample according to agency cost proxies, they find systematic and robust patterns of firms
with significant agency problems being more likely to adhere to the pecking order. They use
firm characteristics, such as firm size, cash flow, and market-to-book ratio, as proxies for the
agency cost. Still, the economic interpretation of these variables is not so clear cut.
In summary, Leary and Roberts (2010) show that the strict pecking order makes a par-
ticularly sharp prediction about equity issuance relative to other forms of financing. That
prediction fails. Even adding further factors to generate an “extended pecking order” does
not resolve the problem. The pecking order offers only very minor improvements over a
completely naive estimator based on no theory. Simple attempts to patch up the pecking
order theory do not resolve the empirical problems, and they lose the beautiful simplicity of
the pecking order.
6 Conclusion
The pecking order theory was originally motivated by the idea that equity has a more
serious adverse selection problem than debt. However, a pecking order structure can also
emerge from other factors such as tax considerations, transaction costs, agency frictions, or
behavioral factors. Furthermore, if adverse selection affects the second moment instead of
the first, the ordering between debt and equity can be reversed. If the firm is choosing a
28

variety of financing contracts, there are commonly multiple equilibria. There is no assurance
that a pecking order would emerge even if adverse selection affects equity. So, evidence for
or against the pecking order is not the same as evidence for or against adverse selection in
financial markets.
How does the pecking order do empirically? Is it rejected, or not? The pecking order
theory is, of course, rejected by some aspects of the data. But that is probably not the most
critical question to ask about the pecking order. Strong assumptions are needed to generate
the pecking order, and it provides a rather stark set of predictions. Stark predictions are
interesting. They put ideas at risk. But their very starkness means that they will likely not
reflect everything that is going on. Accordingly, the following questions seem more useful
than a simple, reject or not, question.
1. What features of the data make sense from a pecking order perspective?
2. What features of the data are surprising from a pecking order perspective?
3. To what extent does adverse selection seem to be the key driving force?
An answer to question (1) is that the pecking order does provide a framework that helps
us to understand several significant patterns in the data. Firms with moderate deficits favor
debt issues. Firms with very high deficits rely much more on equity than on debt. These
financing patterns make sense within the pecking order.
An answer to question (2) is that the pecking order has trouble with equity issues, and
with defining the boundaries at which financing switches. As documented in many papers,
equity issues have become more prevalent in recent decades. Equity repurchasing firms do
generally not pay off all debt first. Many equity issuing firms do not seem to have entirely used
up ‘debt capacity’ under any obvious definition of that capacity. There are even some equity
issues by firms with an operating surplus. The pecking order suggests a sharp discontinuity
of financing methods between surplus firms and deficit firms and another sharp discontinuity
at the debt capacity. The literature provides little or no evidence to support the existence of
these threshold effects. More generally, the pecking order has trouble explaining the inaction
firms depicted in Figure 2.
29

An answer to question (3) is challenging. There is no one-to-one connection between
adverse selection and the pecking order. As a matter of theory, if the firm can issue both
equity and risky debt, there are commonly multiple equilibria. Many of those equilibria do
not exhibit pecking orders. Adverse selection can generate a pecking order. But it can also be
caused by agency considerations, by transaction costs, by tax consideration, by behavioral
decision-making considerations. Under standard tests in the literature, these alternative
underlying motivations are commonly observationally equivalent. Other kinds of tests will
be needed to distinguish among them. As a result, currently, any claimed answer to question
(3), is more a matter of taste and belief than a reflection of established evidence.
Starting with Myers (1984), the pecking order is often presented as a horse race with
the trade-off theory as in Fama and French (2002) and Frank and Goyal (2008). That is
an interesting contest. But a range of relatively subtle considerations is involved in making
that comparison properly. The issues go deeply into the substance of the trade-off theory
and thus are outside the scope of this survey. In our view, the relative merits of the two
approaches are not yet fully settled, decades after Myers (1984) started the race.
The pecking order provides an influential perspective on how firms might use external
debt and equity finance. Some facts roughly align with the theory. However, other facts
do not fit readily in the pecking order. The more literally the theory is interpreted, the
greater the empirical challenges it seems to face. This problem may not be unique to the
pecking order. As a yet unmet challenge for any capital structure theory is to provide a fully
satisfactory account of the key features of the data.
30

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35

Table 1: Cash Flow Budget Constraints, 1971-2018
The table presents the mean values of elements of cash flow budget constraint of publicly traded U.S. firms
in Compustat for 1971 to 2018. The sample excludes regulated, government services, and financial firms.
All cash flow items are scaled by beginning of period assets. Column (1) reports the value-weighted average
(where the observations are value-weighted annually and then averaged across the years). Column (2) reports
the equally weighted averages. Columns (3) to (5) report the averages for three size-based portfolios defined
by the highest, middle, and lowest tercile of the annual size distribution. Size is measured using real values
of total assets. Firms are sorted into four categories based on major financing actions. These are: (1)
“Internal” if firms do not issue net debt or net equity in excess of 5% of assets in year t-1; (2) “Net debt
issue” if firms issue net debt in excess of 5% of assets in year t-1; (3) “Net equity issue” if firms issue net
equity in excess of 5% of assets in year t-1; and (4) “Dual” if they issue both net debt and net equity in
excess of 5% of assets in year t-1. The bottom panel reports the percentage of firm-years that fall into each
of the four groups for the overall sample and the three size-based portfolios.
Firm Size Categories
All All Small Medium Large

VW EW Firms Firms Firms
(1) (2) (3) (4) (5)
N 181,181 181,181 60,412 60,342 60,427
Cash flow budget (fraction of beginning assets)
Investments (Inv) 0.102 0.100 0.080 0.111 0.110

Change in working Capital (∆W orkingCapital) 0.009 0.020 0.016 0.027 0.016
Cash dividends (Div) 0.022 0.010 0.005 0.009 0.016
Change in cash (∆Cash) 0.005 0.011 0.010 0.015 0.007
Needs 0.137 0.140 0.110 0.163 0.148
Internal cash flow (CF ) 0.122 0.065 -0.020 0.099 0.118

Debt issue (DI) 0.084 0.098 0.076 0.105 0.113
Debt repayment (DR 0.064 0.080 0.062 0.089 0.088
Net debt issues (∆D) 0.020 0.018 0.014 0.016 0.025
Equity issue (EI) 0.012 0.066 0.122 0.057 0.020
Equity repurchase (ER) 0.016 0.010 0.005 0.010 0.014
Net equity issues (p∆N ) -0.004 0.057 0.117 0.048 0.005
Financing 0.137 0.140 0.110 0.163 0.148
Financing Decision of Firms (% of Observations)
Internal (Both net issue < 5%) 78.2% 68.4% 64.2% 69.4% 71.7%
Net debt issue (Only net debt issue ≥ 5%) 17.7% 18.0% 14.9% 18.1% 20.9%
Net equity issue (Only net equity issue ≥ 5%) 2.6% 10.4% 16.2% 10.0% 5.0%
Dual issue (Both net issue ≥ 5%) 1.5% 3.2% 4.7% 2.6% 2.3%
36

Table 2: Cash Flow Budgets: Deficit Versus Surplus Firms
The table presents the average cash flow budget constraint. Firms are sorted into three deficit groups: those
generating a surplus (N eeds − CF < −0.05), firms which are in balance (−0.05 ≤ N eeds − CF ≤ 0.05),
and firms with deficits (N eeds − CF > 0.05). Within each deficit group, firms are further sorted into four
categories based on major financing actions. These are: (1) “Internal” if firms do not issue net debt or net
equity in excess of 5% of assets in year t-1; (2) “Net debt issue” if firms issue net debt in excess of 5% of
assets in year t-1; (3) “Net equity issue” if firms issue net equity in excess of 5% of assets in year t-1; and
(4) “Dual” if they issue both net debt and net equity in excess of 5% of assets in year t-1. The bottom four
rows report the percentage of firm-years that fall into each of these four categories for the three portfolios
sorted on financing deficit.
Generating Generating Generating

Surplus Neither Deficits
(1) (2) (3)
N 26,797 101,708 52,676
Cash flow budget (fraction of beginning assets)
Investments (Inv) 0.031 0.067 0.198

Change in working Capital (∆W orkingCapital) -0.019 0.010 0.058
Cash dividends (Div) 0.008 0.012 0.008
Change in cash (∆Cash) -0.008 -0.004 0.048
Needs (N eeds) 0.012 0.085 0.312
Internal cash flow (CF ) 0.116 0.088 -0.004

Debt issuance (DI) 0.061 0.047 0.217
Debt repayment (DR) 0.142 0.051 0.103
Net debt issues (∆D) -0.081 -0.005 0.113
Equity issuance (EI) 0.009 0.008 0.208
Equity repurchase (ER) 0.032 0.006 0.005
Net equity issues (p∆N ) -0.023 0.002 0.203
Financing (F inancing) 0.012 0.085 0.312
Internal (Both net issue < 5%) 95.8% 95.4% 2.4%

Net debt issue (Only net debt issue ≥ 5%) 1.8% 2.1% 56.8%
Net equity issue (Only net equity issue ≥ 5%) 2.4% 2.5% 29.8%
Dual issue (Both net issue ≥ 5%) 0.0% 0.0% 11.1%
37

Table 3: How Important is the Size of the Financing Deficit?
The firm-year observations in Table 2 that are listed as having a financing deficit are included here. They
are sorted into three groups: low deficit, medium deficit, and high deficit. The same statistics as in Table 2
are reported for each groups.
Size of Deficit Categories
Low Medium High Firms with

Deficit Deficit Deficit Deficit
(1) (2) (3) (4)
N 17,528 17,558 17,590 52,676
Cash flow budget (fraction of assets)
Investments (Inv) 0.117 0.170 0.309 0.198

Change in working Capital (∆W orkingCapital) 0.029 0.045 0.100 0.058
Cash dividends (Div) 0.009 0.008 0.005 0.008
Change in cash (∆Cash) -0.003 0.004 0.144 0.048
Needs (N eeds) 0.152 0.227 0.558 0.312
Internal cash flow (CF ) 0.075 0.047 -0.132 -0.004

Debt issuance (DI) 0.144 0.214 0.291 0.217
Debt repayment (DR) 0.089 0.107 0.114 0.103
Net debt issues (∆D) 0.054 0.107 0.178 0.113
Equity issuance (EI) 0.028 0.078 0.516 0.208
Equity repurchase (ER) 0.005 0.005 0.005 0.005
Net equity issues (p∆N ) 0.023 0.073 0.512 0.203
Financing (F inancing) 0.152 0.227 0.558 0.312
Internal (Both net issue < 5%) 7.1% 0.0% 0.0% 2.4%
Net debt issue (Only net debt issue ≥ 5%) 73.1% 65.6% 31.8% 56.8%
Net equity issue (Only net equity issue ≥ 5%) 19.6% 25.8% 43.9% 29.8%
Dual issue (Both net issue ≥ 5%) 0.2% 8.6% 24.3% 11.1%
38

Table 4: Which Firms Do Major Financing Actions?
The table reports distribution across deficit categories for firms choosing particular financing decisions. Four
subsamples are examined. “Internal” examines firms that neither issued net debt nor net equity in excess
of 5% of beginning assets. “Debt” examines firms that issued net debt in excess of 5% of beginning assets.
“Equity” examines subsamples of firms that issued equity in excess of 5% of beginning assets. “Dual”
examines firms that issued both net debt and net equity in excess of 5% of beginning assets. Columns (1)
to (3) report the percentage of firms in each of the subsamples that are generating a surplus, generating
neither, or generating a deficit. Columns (4) to (6) further classify the deficit firms into three groups based
on the intensity of their deficit. Low, medium, and high deficit firms are the bottom, middle, and top tercile
of deficit firms, respectively.
Deficit categories Intensity of deficit
Generating Generating Generating Low Medium High

Surplus Neither Deficit Deficits Deficits Deficits
(1) (2) (3) (4) (5) (6)
Internal (N=123,973) 20.7% 78.3% 1.0% 1.0% 0.0% 0.0%
Debt (N=32,536) 1.5% 6.5% 92.0% 39.4% 35.4% 17.2%
Equity (N=18,851) 3.4% 13.4% 83.2% 18.3% 24.0% 41.0%
Dual (N=5,821) 0.0% 0.0% 100.0% 0.6% 25.9% 73.4
39

2
1.5
1
.5
0
−.5
0 10 20 30 40 50 60 70 80 90 100
Deficit Group
Net debt issues Net equity issues

.015
.005
−.005
−.015
30 35 40 45 50 55 60
Deficit Group
Net debt issues Net equity issues
Figure 1: Average net debt and net equity issuances to lagged assets for firms sorted into
equally-sized bins based on the size of the financing deficit to lagged assets, 1971-2018.
The bins to the left (right) of the dashed vertical line represent firms generating financing
surpluses (deficits). The sample comprises U.S. firms on Compustat. Financial firms and
utilities are excluded. Financing deficit equals cash dividends plus investments in fixed assets
plus increases in cash holdings plus changes in working capital minus internal cash flow. Net
debt issues to assets equals debt issues minus debt redemptions. Net equity issues equal
stock issues minus stock repurchases. The data are obtained from Compustat fund flow
statements.
40

1
.9
.8
.7
.6
.5
.4
.3
.2
.1
−.1 0
0 10 20 30 40 50 60 70 80 90 100
Deficit Group
Zero Change Debt Zero Change Shares Outstanding
Figure 2: The figure plots fraction of firms exhibiting no change in debt (solid line) and
no change in shares outstanding (dashed line) for each of the 100 bins based on the size of
the financing deficit. The bins to the left (right) of the dashed vertical line represent firms
generating financing surpluses (deficits). The sample comprises U.S. firms on Compustat.
Financial firms and utilities are excluded. Financing deficit equals cash dividends plus
investments in fixed assets plus increases in cash holdings plus changes in working capital
minus internal cash flow.
41

Appendix A: Variable construction
The variables are constructed based on the cash flow statements provided in Compustat. We include Com-
pustat mnemonics to identify the Compustat variable names. All of the variables are standardized by total
assets ( or ’at’) at the end of the previous year.
Symbol Variable Name Compustat mnemonics

a
Inv Investment (capx+acq+ivch-siv-sppe-ivstch-ivaco)/att−1
Div b Cash dividends dv/att−1
∆W orkingCapitalc Change in working capital (recch+invch+apalch+txach+aoloch)*(-1)/att−1
∆Cashd Change in cash chech/att−1
N eeds Needs Inv + ∆W orkingCapital + Div + ∆Cash
CF e Cash flow (ibc+dpc+xidoc+txdc+esubc+sppiv+fopo+exre)/att−1
Def icit Financing deficit N eeds - CF
∆Df Net debt issuance (dltis-dltr+dlcch+txbcof+fiao)/att−1
DI Debt issue (dltis+max[dlcch,0])/att−1
DR Debt repayment (dltr+min[dlcch,0]*(-1))/att−1
p∆N g Net equity issuance (sstk-prstkc)/att−1
EI Equity issue sstk/att−1
ER Equity repurchase prstkc/att−1
F inancing Financing CF + ∆D + p∆N
ExtF in External financing ∆D + p∆N
a
The numerator of Inv is constructed as follows. For format code 7, it is capital expenditure (capx) +
acquisitions (aqc) + increase in investment (ivch) - sale of investment (siv) - sale of property, plant and
equipment (sppe) - short-term investments-change (ivstch) - investing activities-other (ivaco). For format
codes 1, 2, and 3, replace ivaco with the negative of use of funds-other (-1*fuseo).
b
The numerator of Div is cash dividends (dv).
c
The numerator of ∆W orkingCapital is constructed as follows. For format code 7, it is the negative of the
sum of accounts receivable-decrease(increase) (recch), inventory-decrease(increase) (invch), accounts payable
and accrued liabilities-increase(decrease) (apalch), income taxes-accrued-increase(decrease) (txach), and
assets and liabilities-other (net change) (aoloch). For format code 1, the numerator of ∆W orkingCapital
is wcapch. For format codes 2 and 3, it is (-1)*wcapc.
d
The numerator of ∆Cash for format codes 2, 3, and 7 is cash and cash equivalents-increase(decrease)
(chech). For format code 1, chech is recoded to 0.
e
The numerator of CF is constructed as follows. For format code 7, it is income before extraordinary items
(ibc) + depreciation and amortization (dpc) + extraordinary items and discontinued operations (xidoc)
+ deferred taxes (txdc) + equity in net loss (earnings) (esubc) + sale of property, plant, and equipment
and sale of investments-loss(gain) + funds from operations-other (fopo) + exchange rate effect (exre). For
format codes 1, 2, or 3, replace the item exre with sources of funds-other (fsrco).
f
The numerator of ∆D is constructed as follows. For format code 7, it is long-term debt issuance (dltis) -
long-term debt-reduction (dltr) + changes in current debt (dlcch) + excess tax benefits of stock options
(txbcof) + financing activities-other (fiao). The items txbcof and fiao are both zero for format codes 1, 2,
and 3. Additionally, dlcch is recoded to zero for format code 1.
g
The numerator of Net equity issuance (p∆N ) is sale of common and preferred stock (sstk) - purchase of
common and preferred stock (prstkc).
42

The Pecking Order Theory of Capital Structure: Where Do We Stand?

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2.1 Defining a firm flow budget

OP ERt + ∆Dt + pt ∆Nt + ρt−1 Casht−1 =

Using this definition, we get a standard Flow Budget Constraint,

CF + ∆Dt + pt ∆Nt = Invt + ∆W orkingCapitalt + Divt + ∆Casht . (2)

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N eedst ≡ Invt + ∆W orkingCapitalt + Divt + ∆Casht . (3)

CFt + ∆Dt + pt ∆Nt = N eedst . (4)

DEFt ≡ N eedst − CFt = ∆Dt + pt ∆Nt . (5)

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2.2 What are real-world flow budgets like?

— Table 1 about here —

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2.3 Defining the pecking order

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3 Pecking order statistics

3.1 Financing actions by surplus and deficit firms

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— Table 2 about here —

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3.2 Financing actions by deficit size

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— Table 3 about here —

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— Figure 1 about here —

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3.3 Which firms do nothing?

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— Figure 2 about here —

3.4 Which firms undertake major financing actions?

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— Table 4 about here —

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4.1 Adverse Selection

chance that the firm is of type H.

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4.2 Other Justifications

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4.2.4 Other mechanisms

5.1 The Shyam-Sunder and Myers (1999) test

∆Dit = a + bP O DEFit + eit . (6)

The key prediction is βP O = 1, so Shyam-Sunder and Myers (1999) essentially assume

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5.2 The Fama and French (2002) test

Electronic copy available at: https://ssrn.com/abstract=3540610

5.3 The Leary and Roberts (2010) test

Electronic copy available at: https://ssrn.com/abstract=3540610

Electronic copy available at: https://ssrn.com/abstract=3540610

Electronic copy available at: https://ssrn.com/abstract=3540610

Electronic copy available at: https://ssrn.com/abstract=3540610

Electronic copy available at: https://ssrn.com/abstract=3540610

Electronic copy available at: https://ssrn.com/abstract=3540610