Why Pecking Order Theory Should be Included in Introductory Finance Courses

The majority of students majoring in various business administration emphases take only one finance course (Introductory Financial Management) while completing the requirements of their degrees. A primary topic commonly covered in most introductory finance courses is capital structure, with a discussion that often culminates with a discussion of optimal capital structure. Invariably the leading textbooks present optimal capital structure within the framework of the agency cost/tax shield trade-off model that evolved from Modigliani and Miller’s capital structure irrelevance hypothesis. While this approach has solid grounding in value maximization arguments and capital market equilibrium theory, it nonetheless fails to explain several commonly observed - and reported - practices in modern corporate finance. Pecking order theory offers an intriguing addition to the explanation of optimal capital structure, even in an introductory course. However, few introductory textbooks give the theory much more than a cursory mention, if it is indeed mentioned at all. The purpose of this paper is to make a case for including pecking order theory in any discussion of optimal capital structure