The pecking order hypothesis is a perspective based upon repeated observations of how corporations seem to raise funds over time. The theory behind this perspective was developed from the information asymmetry problem, namely, that management knows more about the firm and its opportunities than the financial marketplace does, and that management does not want to be forced to issue equity when stock prices are depressed. Evidence shows that corporations mainly rely on internal funds, especially new additions to retained earnings, to finance capital budgeting projects. If they need outside financing, firms typically issue debt first, as it poses lower risk on the investor than equity and lower cost on the corporation. Should a firm approach its debt capacity, it may well favor hybrid securities, such as convertible bonds, over common stock. As a last resort, the firm will issue commonequity. Thus, firms have a financing ‘‘pecking order,’’ rather than a goal to maintain a specific target debt-to-equity ratio over time. Under this pecking order hypothesis, financial theory has come full circle. Like Modigliani and Miller’s original work, the pecking order hypothesis implies that firms have no optimal debt-toequity ratios. Instead, they follow the pecking order, exhausting internal equity (retained earnings) first and resorting to external equity (new issues of common stock) last. Observed debt ratios represent nothing more than the cumulative result of a firm’s need to use external financing over time. Under the pecking order hypothesis, firms with high profitability should have lower debt ratios, as these firms’ additions to retained earnings reduce their need to borrow. Under the static tradeoff hypothesis, a firm with high profitability ratios should have a lower probability of bankruptcy and a higher tax rate, thus leading to higher debt ratios. Most empirical evidence resolves this conflict in favor of the pecking order hypothesis; studies find that more profitable firms tend to have lower debt ratios. What if the pecking order hypothesis is correct and the firm has no optimal capital structure? Recall that the cost of capital represents the minimum required return on capital budgeting projects. Management must determine the firm’s cost of capital regardless of personal beliefs about the existence of an optimal capital structure. Target capital structure weights should reflect management’s impression of a capital structure that is sustainable in the long run and that allows for financing flexibility over time. Should a firm fail to earn its cost of capital, shareholder wealth will decline. The debate over optimal capital structure is not resolved. Empirical studies and surveys of corporate practice have supported both the static tradeoff and the pecking order theories. Part of the uncertainty over which perspective is correct comes from blends between capital structure choices that depart from ‘‘plain vanilla’’ debt and equity. In recent decades, firms have devised myriad financing flavors. Consequently, many firms have several layers of debt and several layers of equity on their balance sheets. Debt can be made convertible to equity; its maturity can be extended, or shortened, at the firm’s options; debt issues can be made senior or subordinate to other debt issues. Likewise, equity variations exist. Preferred equity has gained popularity since it increases a firm’s equity without diluting the ownership and control of the common shareholders; it also increases future financing flexibility by expanding the firm’s capacity for debt issues. Firms can have different classes of common equity, providing holders with differing levels of dividend income or voting rights. In sum, pecking order in long-term financing is a hierarchy of long-term financing strategies, in which using internally generated cash is at the top and issuing new equity is at the bottom.