Stewart Myers and Nicholas Majluf's 1984 argument starts from a fact nobody disputes: management knows more about the firm's prospects than the market does. A manager who believes the shares are underpriced will not issue them, because doing so sells a rupee of value for less than a rupee and the loss falls on continuing holders. A manager who believes they are overpriced will issue enthusiastically.
Why does an equity issue lower the share price?
Investors know this, so they read an equity issue as bad news and mark the price down on the announcement. That markdown is the cost of the asymmetry, and it is why financing sources get ranked by how little information they reveal. Retained earnings reveal nothing and come first. Debt reveals little, because its payoff is nearly flat in the firm's prospects, and comes second. Equity reveals the most and comes last.
The prediction is testable and has been tested. Seasoned equity announcements by United States industrial firms have averaged an abnormal return of roughly negative 3%, a magnitude reported by Asquith and Mullins (1986) and by Masulis and Korwar (1986) among others, while straight debt announcements average close to zero. On Winslow Instrument Corp's pre-announcement market value of $2,000 million, negative 3% is $60 million, which is 20 cents on every dollar of the $300 million being raised. Any financing comparison that ignores it has left out a cost larger than most of the ones it included.
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Does the evidence support the pecking order?
The empirical record on the theory as a whole is mixed in an informative way. Shyam-Sunder and Myers (1999) found that debt absorbed nearly all the financing deficit in a sample of mature firms, which is what the pecking order predicts. Frank and Goyal (2003) found the ordering fails for small, high-growth firms, which issue the most equity of any group. Those are precisely the firms with the worst information asymmetry, so the theory predicts they should issue the least. A theory that works where asymmetry is mild and fails where it is severe is describing something other than asymmetry, and the leading candidate is the financing constraint: a young firm with no assets and no earnings cannot borrow, whatever it would prefer.
Pecking order of sources vs ranking of uses
One reconciliation to hold explicitly, because it looks like a contradiction and is not. The capital-allocation work in the valuation phase ranks the uses of capital by value created per rupee and refuses to fund anything below the hurdle. The pecking order ranks the sources of capital by information cost. Those are different axes. A firm can hold a strict zero-based ranking of uses and a strict pecking order of sources at the same time, and a good allocator does. The two only collide when a project clears the hurdle and the only remaining source is equity at a price management believes is too low, and that collision is the entire content of the financial-flexibility argument.