Introduction to Finance

pecking order hypothesis
, fi nancial theory implies that fi rms have no optimal 
debt/equity ratios.
20
Instead, they follow the pecking order, exhausting internal equity (retained 
earnings) fi rst and resorting to external equity (new issues of common stock) as a last resort. 
Observed debt ratios represent the cumulative result of a fi rm’s need to use external fi nan-
cing over time and refl ect the joint eff ects of growth, attractive investment opportunities, and 
dividend policy.
Under the pecking order hypothesis, fi rms with higher profi tability should have lower debt 
ratios, as these fi rms’ additions to retained earnings reduce their need to borrow. Under the 
static trade-off hypothesis, a fi rm with higher profi tability should have a lower probability of 
bankruptcy and a higher tax rate, thus leading to 
higher 
debt ratios. Most empirical evidence 
resolves this confl ict in favor of the pecking order hypothesis; studies show more-profi table 
fi rms tend to have lower debt ratios.
Market Timing 
Like the pecking order hypothesis, this perspective is based upon observations of how fi rms 
raise funds in practice. The 
market timing hypothesis
states that fi rms time the equity mar-
ket by issuing stock when their stock prices are high and repurchasing shares when their stock 
values are low.
21
Research studies have found that fi rms prefer to issue stock when earnings 
expectations by the market are overly optimistic. Managers have admitted that overvaluation and 
undervaluation of their stock is an important consideration in issuing equity.
22
Researchers argue 
that fi rms, after issuing or repurchasing equity in attempts to time the equity market, do not move 
the fi rm back to its former capital structure. Rather, low-leverage fi rms are those that were, on 
balance, successful in raising funds when their equity market values were high; high-leverage 
fi rms, on average, are those that raised funds when their equity market values were low.