Explain 'pecking order hypothesis' relevant to capital structure planning.

The Pecking order theory is based on the assertion that managers have more information about their firm than investors. This disparity of information is referred to as asymmetrical information. Other things being equal, because of asymmetrical information, managers will issue debt when they are positive about their firm's future prospects and will issue equity when they are unsure. The cost of equity includes the cost of new issue of shares and the cost of retained earnings. The cost of debt is cheaper than the cost of both these sources of equity funds. Amongst the cost of new issue and retained earnings, the latter is cheaper because personal taxes have to be paid by shareholders on distributed earnings while no taxes are paid on retained earnings and also no floatation costs are incurred when the earnings are retained. As a result, between the two sources of equity funds, retained earnings are preferred. It has been found in practice that firms prefer internal finance. If the internal funds are not sufficient to meet the investment outlays, firms go for external finance, issuing the safest security first. They start with debt, then possibly hybrid securities such as convertible debentures, then perhaps equity as a last resort. It is called Pecking order theory since there is not a well defined debt equity target and there are two kinds of equity, internal and external, one at the top of pecking order and one at the bottom.