There is ongoing debate about the empirical performance of the pecking order theory of financing proposed by Myers (1984) and Myers and Majluf (1984). The theory is based on asymmetric information between the firm’s investors and its managers. Due to the valuation discount that less-informed investors apply to newly issued securities, firms resort to internal funds first, and then debt and equity last to satisfy their financing needs.
The empirical evidence for the theory has been mixed, in part due to shortcomings of the empirical tests used. As a result, the central prediction of the theory that of asymmetric information driving pecking order behavior has not been adequately evaluated. In this paper, we examine this central prediction within the context of a firm’s life cycle.
We identify firms in two major life cycle stages, namely growth and maturity. We find that growth firms have a greater need for external financing and have smaller debt capacities compared to mature firms. These two factors greatly affect a firm’s financing decision and it is difficult to assess the empirical performance of the pecking order theory without accounting for differences in these characteristics across firms (Lemmon and Zender, 2007).
In sorting firms according to growth and maturity stages, we are confident that external financing needs and levels of debt capacity are more homogeneous. We find that, within a life cycle stage and upon sufficiently controlling for a firm’s debt capacity, firms with the highest adverse selection costs due to information asymmetry are the ones following the pecking order more closely, consistent with the theory.