What is Pecking Order theory

In corporate finance, the pecking order theory (or pecking order model) postulates that the cost of financing increases with asymmetric information.
Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a "last resort". Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance.
The pecking order theory is popularized by Myers and Majluf (1984) where they argue that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance.
The pecking order theory begins from the asymmetry of information in the organization. Asymmetric information is an unequal distribution of information. The managers generally have more information about company’s performance, prospects and risks than outside creditors or investors. Some companies have a high level of asymmetric information like companies with a complex or technical product, companies with less accounting transparency etc. Higher the asymmetry of information, higher the risk in the company.
If a company does not have sufficient retained earnings, then it will have to raise money through external sources. Managers would prefer debt over equity because the cost of debt is lower compared to the cost of equity. The company issuing new debt will increase the proportion of debt in the capital structure and it will provide a tax shield. So this will reduce the weighted average cost of capital (WACC). After a certain point, increasing the leverage in capital structure will be very risky for the company. In such scenarios, the company will have to issue new equity shares as a last resort.
DIFFERENCE BETWEEN STATIC THEORY AND PECKING ORDER THEORY:
The static trade-off theory and the pecking order theory are two financial principles that help a company choose its capital structure. Both play an equal role in the decision-making process depending on the type of capital structure the company wishes to achieve. The pecking order theory, however, has been empirically observed to be most used in determining a company's capital structure.
The static trade-off theory is a financial theory based on the work of economists Modigliani and Miller. With the static trade-off theory, and since a company's debt payments are tax deductible and there is less risk involved in taking out debt over equity, debt financing is initially cheaper than equity financing. This means a company can lower its weighted average cost of capital (WACC) through a capital structure with debt over equity. However, increasing the amount of debt also increases the risk to a company, somewhat offsetting the decrease in the WACC. Therefore, the static trade-off theory identifies a mix of debt and equity where the decreasing WACC offsets the increasing financial risk to a company.
The pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If this source of financing is unavailable, a company should then finance itself through debt. Finally, and as a last resort, a company should finance itself through the issuing of new equity. This pecking order is important because it signals to the public how the company is performing. If a company finances itself internally, it means it is strong. If a company finances itself through debt, it is a signal that management is confident the company can meet its monthly obligations. If a company finances itself through issuing new stock, it is normally a negative signal, as the company thinks its stock is overvalued and it seeks to make money prior to its share price falling.

WHICH ONE IS APPLICABLE IN PAKISTAN?
As per Pecking Order Theory in capital structure formulation internally generated resources would have first priority followed by debt issuance whereas equity is used as last resort. In its strong form, the Pecking Order Theory sustains that equity issues would never occur, whereas in its weak form, limited amounts of issues are acceptable. The methodology adopted in this empirical study involves cross-section regressions and the testing of hypotheses stemming from the underlying theory in its strong and weak forms. The sample of capital structure of non-financial firms from KSE is considered from for 2001 to 2008. The statistical tool of panel data regressions analysis is used to test different firm’s data. The value of R2, t-test and F-Stat indicate firm in KSE support weak form of pecking order theory i.e. the option of using internal equity and debt is more preferred and limited amount of external equity is used for reinvestment and fund raising purpose. Pakistani firms should straight away go for debt instead of external equity for fund raising purpose.