What is meant by the “pecking order approach”?

The pecking order approach is a sequence of raising financing that many companies seem to follow, even though it ignores the recommendations of the various debt-equity-mix theories. The approach is to finance first with retained earnings, second with payables and bank debt, third with bonds and other more complex debt, and fourth with common stock issues. Three explanations for the pecking order approach are:

(1) It is the easiest way for financial managers to obtain funds since it requires the least amount of work and limits the need for potentially complex negotiations.

(2) It raises funds in the order of low to high flotation costs, keeping these costs to a minimum.

(3) The financial markets often take the announcement of a stock sale as negative information, assuming that management would only sell new shares if its share price were high, hence the stock was overvalued. When management announces a stock sale, it signals this previously inside information (asymmetric information) to the markets. By putting stock sales last on the list, the financial manager minimizes the possibility of this reduction in the firm’s share price taking place.