Is Pecking Order

Theory Applicable in
India?
SECTOR: OIL AND GAS
PECKING ORDER THEORY
Firms often face financial deficits or availability of surpluses based on their existing
cash flows and future investment requirements. If the investment needs are more than
their existing internal funds, firms tend to have funds deficiency. In the opposite
situation, when the existing cash flows are over and above a firm’s investment
requirements, they are likely to be in a situation of surplus. There is rarely a situation
when firms exactly match internal funds with their investment needs. Depending upon
their current and expected situation, firms may opt to raise or retire external funds
following the pecking order theory.

Pecking order theory proposes that firms prefer internal to external funds in a hierarchy
of internal cash flows, followed by debt and then equity (Myers, 1984). In a deficit
situation, firms prefer issuing debt to equity. In a surplus situation, a firm redeems debt
obligations, then repurchases equity. According to this theory, internal funds have no
information asymmetry or flotation costs and are therefore given a priority over
external financing. Equity is issued only if the existing debt capacity
limits are exhausted

INTERNAL FINANCING VS EXTERNAL FINANCING

The pecking order theory begins from the asymmetry of information in the
organization. Asymmetric information is an unequal distribution of information. The
managers generally have more information about company’s performance, prospects
and risks than outside creditors or investors. Some companies have a high level of
asymmetric information like companies with a complex or technical product,
companies with less accounting transparency etc. Higher the asymmetry of
information, higher the risk in the company.

Also, it is not possible for the investors to know everything about a company. So, there
will always be some amount of information asymmetry in every company. If a creditor
or an investor has less information about the company, he/she will demand higher
returns against the risk taken. Along with providing higher returns, the company will
have to incur costs to issue the debt and equity. It will also have to incur some agency
cost like paying the board of directors’ fees to ensure shareholders’ interests are
maximized. All these reasons make retained earnings a cheaper and convenient
source of finance than external sources.

DEBT FINANCING VS EQUITY FINANCING

If a company does not have sufficient retained earnings, then it will have to raise
money through external sources. Managers would prefer debt over equity because the
cost of debt is lower compared to the cost of equity. The company issuing new debt

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will increase the proportion of debt in the capital structure and it will provide a tax
shield. So, this will reduce the weighted average cost of capital (WACC).

After a certain point, increasing the leverage in capital structure will be very risky for
the company. In such scenarios, the company will have to issue new equity shares as
a last resort.

SIGNALS FROM THE CHOICE OF FINANCE

Company’s choice of finance sends some signals in the market. If a company is able
to finance itself internally, it is considered to be a strong signal. It shows that company
has enough reserves to take care of funding needs. If a company issues a debt, it
shows that management is confident to meet the fixed payments. If a company
finances itself with new stock, it’s a negative signal. The company generally issues
new stock when it perceives the stock to be overvalued.

All the above-mentioned logics are applied to develop the hierarchy of pecking order
theory. This hierarchy should be followed while taking decisions related to capital
structure.

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RESEARCH METHODOLOGY
Quantitative research methodology has been used to test the existence or absence of
pecking order theory in Indian companies belonging to oil and gas sector. Statistical
methods have been used to carry out the tests. The use of regression has been made
between various variables to check the correlation between each pair of variables and
degree of influence exerted by each on the other. Sample size of 16 companies that
belonged to different market capitalization categories were taken for the purpose of
the test. The data collected belonged for the year March 2009 to March 2018 for all
the sample companies.

Post collection of the data of the sample companies, the companies were segregated
in deficit and surplus financing companies as well as different market capitalization.

The list of sample companies:

 Aban Offshore
 Bharat Petroleum Corporation Limited (BPCL)
 Chennai Petroleum Corporation Limited (CPCL)
 Deep Industries
 Dolphin Offshore
 Gas Authority of India Limited (GAIL)
 Gujarat Gas
 Hindustan Petroleum Corporation Limited (HPCL)
 Indian Oil and Gas Corporation (IOCL)
 Indraprastha Gas
 Mangalore Refinery and Petrochemicals Limited (MRPL)
 Mahanagar Gas
 Oil and Natural Gas Corporation (ONGC)
 Oil India
 Petronet LNG
 Reliance

LIMITATIONS
The financials of the companies have been collected from secondary sources.
Moneycontrol.com was used to aggregate the data instead of using companies
published annual report for the time period taken into consideration. Hence, there can
be cases of discrepancies between the two sources of data.

A simple regression analysis has been done in Ms-excel instead of using any
advanced software to carry out the statistical tests due to limited know how.

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SEGREGATION BETWEEN SURPLUS AND DEFICIT
FINANCING COMPANIES
The following framework calculates deficit/surplus of firm i in year t. A negative value
indicates a deficit, while a positive value is considered a surplus

where SURt is the positive or negative surplus in year t;

Ct: the net cash from operating activities (adjusted) of firm i in year t (i.e. earnings after
taxes + depreciation +amortisation ±other non-cash adjustments± changes in noncash
current assets± changes in operating/current liabilities ± changes in short-term
borrowings −dividends paid);

It: the net capital investments of firm i in year t (i.e. Purchase of fixed assets − sale of
fixed assets + purchase of long-term investments −sale of long-term investments).

SEGREGATION BETWEEN LARGE MARKET

CAPITALIZATION, MEDIUM MARKET CAPITALIZATION
AND SMALL MARKET CAPITALIZATION COMPANIES
The market capitalization of all the 16 sample companies were recorded and as per
the following rule, the companies were segregated into different categories:

 Market Capitalization greater than ₹20,000 crore: Large capitalization

companies

 Market Capitalization between ₹5,000- ₹20,000 crore: Medium capitalization

companies

 Market Capitalization less than ₹5,000 crore: Small capitalization companies

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TESTING PECKING ORDER THEORY WITH HELP OF
REGRESSION BETWEEN BORROWINGS AND OPERATING
PROFIT
Independent (X variable): Operating Profit
Dependent (Y variable): Borrowings

We collect the operating profit data from the income statement and borrowings from
balance sheet.

Regression between Borrowings & Operating Profit

2
Company R P-Value Intercept Co-efficient of X
Dolphin Offshore 37.87% 0.06 84.88470626 0.473929306
GAIL (India) 0.77% 0.81 3950.546362 0.272541819
HPCL 15.38% 0.26 28596.75592 -0.657698148
Petronet LNG 28.62% 0.11 3351.650738 -0.408026826
Indraprastha Gas 1.18% 0.76 248.398606 -0.089187516
Oil India 0.89% 0.80 6380.179364 -0.523977662
MRPL 1.17% 0.77 6516.570197 -0.186437
Gujarat Gas 77.28% 0.00 401.0033779 2.7050351
Mahanagar Gas
Ltd. 59.60% 0.01 20.89571143 -0.025235292
CPCL 0.25% 0.89 4440.230299 0.066721838
BPCL 3.24% 0.62 21769.33224 -0.182121795
Reliance 64.93% 0.00 -40242.9478 4.83674937
Deep Industries 83.11% 0.00 32.28969883 1.516711962
Aban Offshore 1.25% 0.76 14000.17347 0.126799136
ONGC 0.01% 0.98 6522.967826 -0.011861083
IOCL 0.47% 0.85 65164.29652 0.102016815
Average 23.50% 48.01% 7577.326703 0.500997502

With increase in operating profit, it is assumed that the financials of the company are
improving and vice versa. Hence, with improving financial position, the company will
be able to fund itself via internal funding and would not resort to borrowings or there
would be decrease in borrowings.

To provide evidence to pecking order theory we expect a negative regression between

the two variables.

8 out of 16 sample companies show negative regression that is 50%. These

companies have made altercations in their borrowing in tune with change in operating
profits and hence can be said to follow pecking order on the other hand, another 50%
of the companies show absence of pecking order or any such regression.

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Large Cap
Companies

Regression between Borrowings & Operating Profit

Co-efficient of
2
Company Market Capitalization (Cr.) R P-Value Intercept X
Dolphin Offshore 83189 37.87% 0.06 84.88470626 0.473929306
GAIL (India) 81408 0.77% 0.81 3950.546362 0.272541819
HPCL 42095 15.38% 0.26 28596.75592 -0.657698148
Petronet LNG 35460 28.62% 0.11 3351.650738 -0.408026826
Indraprastha Gas 20307 1.18% 0.76 248.398606 -0.089187516
Oil India 20213 0.89% 0.80 6380.179364 -0.523977662

Medium Cap
Companies

Regression between Borrowings & Operating Profit

Co-efficient of
2
Company Market Capitalization (Cr.) R P-Value Intercept X
MRPL 12820 1.17% 0.77 6516.570197 -0.186437
Gujarat Gas 10335 77.28% 0.00 401.0033779 2.7050351
Mahanagar Gas
Ltd. 9245 59.60% 0.01 20.89571143 -0.025235292

Small Cap
Companies

Regression between Borrowings & Operating Profit

Co-efficient of
2
Company Market Capitalization (Cr.) R P-Value Intercept X
CPCL 3896 0.25% 0.89 4440.230299 0.066721838
BPCL 860 3.24% 0.62 21769.33224 -0.182121795
Reliance 839 64.93% 0.00 -40242.9478 4.83674937
Deep Industries 473 83.11% 0.00 32.28969883 1.516711962
Aban Offshore 386 1.25% 0.76 14000.17347 0.126799136
ONGC 195 0.01% 0.98 6522.967826 -0.011861083
IOCL 147 0.47% 0.85 65164.29652 0.102016815

On sorting the companies in terms of market capitalization, we see 4 out of 6 large

cap companies show negative regression where as only 2 out of 7 small cap
companies show negative regression.

It can be concluded that large cap companies are more likely to follow pecking order
theory in comparision to small cap companies.

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 TESTING PECKING ORDER THEORY WITH THE HELP OF
REGRESSION BETWEEN BORROWINGS AND RESERVES

Independent (X variable): Reserves

Dependent (Y variable): Borrowing

We collect the data for reserves and borrowings from balance sheet.

Regression between Borrowings & Reserves

2
Company R P-Value Intercept Co-efficient of X
Dolphin Offshore 5.02% 0.53 77.05279993 0.107283054
GAIL (India) 10.67% 0.36 2063.926102 0.133900975
HPCL 12.37% 0.32 31913.09347 -0.470998082
Petronet LNG 31.30% 0.09 3208.702896 -0.133566189
Indraprastha Gas 17.51% 0.23 337.9416557 -0.091311624
Oil India 67.87% 0.00 -7411.508428 0.623578546
MRPL 19.16% 0.21 2395.221758 0.718100947
Gujarat Gas 84.31% 0.00 311.5751544 1.506577451
Mahanagar Gas
Ltd. 66.77% 0.00 19.48365704 -0.008636696
CPCL 25.26% 0.14 6495.788202 -0.729147219
BPCL 0.66% 0.82 21269.34225 -0.039261943
Reliance 95.30% 0.00 -65495.53254 1.069513757
Deep Industries 74.34% 0.00 12.00354355 0.649057191
Aban Offshore 0.07% 0.94 14252.16647 -0.017020235
ONGC 0.12% 0.92 7483.718315 -0.008496189
IOCL 0.49% 0.85 63349.01255 0.055216097
Average 31.95% 33.88% 5017.624242 0.210299365

With increase in reserves the firm should reduce its borrowings or in other words,
redemption of debentures should take place. The sample companies taken all exhibit
surplus for majority of the years, therefore ideally as per pecking order theory, the
excess reserves should be utilised in the redemption of debt.

We take reserves as the independent and borrowing as the dependent variable. The
regression result should give a negative relation, since increase in reserves is followed
by decrease in debt and vice versa.

Once again, 8 out of 16 companies show a negative relation whereas the rest 50%
show positive relation. Also, companies with negative correlation, have very low
degree of influence as can be seen by value below or near about 0.5 in both cases (in
absolute terms).

Large Cap Companies

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 Regression between Borrowings & Reserves
Market Capitalization Co-efficient of
2
Company (Cr.) R P-Value Intercept X
Dolphin Offshore 83189 5.02% 0.53 77.05279993 0.107283054
GAIL (India) 8140810.67% 0.36 2063.926102 0.133900975
HPCL 4209512.37% 0.32 31913.09347 -0.470998082
Petronet LNG 3546031.30% 0.09 3208.702896 -0.133566189
Indraprastha Gas 2030717.51% 0.23 337.9416557 -0.091311624
-
Oil India 20213 67.87% 0.00 7411.508428 0.623578546

Medium Cap
Companies

Regression between Borrowings & Reserves

Market Capitalization Co-efficient of
2
Company (Cr.) R P-Value Intercept X
MRPL 12820 19.16% 0.21 2395.221758 0.718100947
Gujarat Gas 10335 84.31% 0.00 311.5751544 1.506577451
Mahanagar Gas Ltd. 9245 66.77% 0.00 19.48365704 -0.008636696

Small Cap Companies

Regression between Borrowings & Reserves

Market Capitalization Co-efficient of
2
Company (Cr.) R P-Value Intercept X
CPCL 3896 25.26% 0.14 6495.788202 -0.729147219
BPCL 860 0.66% 0.82 21269.34225 -0.039261943
-
Reliance 839 95.30% 0.00 65495.53254 1.069513757
Deep Industries 473 74.34% 0.00 12.00354355 0.649057191
Aban Offshore 386 0.07% 0.94 14252.16647 -0.017020235
ONGC 195 0.12% 0.92 7483.718315 -0.008496189
IOCL 147 0.49% 0.85 63349.01255 0.055216097

Comparing the result with respect with market capitalization, we see that 50% of large
cap companies have negative correlation whereas approximately 60% of small cap
companies show negative correlation.

Companies with negative correlation can be said to follow pecking order theory but
taking into consideration the low degree of influence, we cannot make any comment.

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TESTING PECKING ORDER THEORY WITH THE HELP OF
REGRESSION BETWEEN BORROWINGS AND SURPLUS

Independent (X variable): Surplus

Dependent (Y variable): Borrowings

Surplus was calculated for every firm by using the formula stated previously and
borrowing have been taken from the balance sheet

Regression between Borrowings & Surplus

2
Company R P-Value Intercept Co-efficient of X
Dolphin Offshore 0.64% 0.90 106.2973342 -0.083224008
GAIL (India) 2.44% 0.67 6935.395917 -0.1950012
HPCL 27.77% 0.12 29632.22048 -0.429197088
Petronet LNG 26.14% 0.13 3172.354669 -0.201452532
Indraprastha Gas 0.35% 0.87 214.4081395 -0.026110747
Oil India 17.24% 0.23 2347.698009 0.576535481
MRPL 0.19% 0.91 5712.408423 0.056579867
Gujarat Gas 52.39% 0.02 532.5069755 1.406692212
Mahanagar Gas
Ltd. 48.69% 0.02 19.34966528 -0.015874702
CPCL 4.65% 0.61 5096.660165 -0.328341491
BPCL 29.36% 0.13 23530.29567 -0.250566124
Reliance 72.64% 0.00 26252.15253 1.430354166
Deep Industries 93.01% 0.00 10.7062527 0.992380989
Aban Offshore 70.78% 0.00 13305.66977 0.401858561
ONGC 0.80% 0.81 3536.461731 0.048988843
IOCL 5.12% 0.59 78563.08172 -0.194646631
Average 28.26% 37.56% 12435.47922 0.199310975

A common trend that was observed among the samples companies was that they
showed surplus for majority of the years. Now a company with surplus for most of the
years is expected to fund its investing needs with internal financing and hence a
reduction in external borrowing should be observed.

We take surplus as the independent variable and borrowing as the dependent variable,
and run the regression. To prove the existence of the pecking order theory, the result
should give a negative correlation with high regression coefficient to denoted high
degree of influence.

9 out of 16 companies show a negative correlation whereas 7 out of 16 companies

show positive correlation. Among the companies showing negative correlation, 5 are
large cap companies and 1 medium cap and 3 small cap companies. However, in all
case the degree of influence is very low as can be seen by low regression coefficient.

Large Cap Companies

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 Regression between Borrowings & Surplus
Market Capitalization Co-efficient of
Company (Cr.) R2 P-Value Intercept X
Dolphin Offshore 83189 0.64% 0.90 106.2973342 -0.083224008
GAIL (India) 81408 2.44% 0.67 6935.395917 -0.1950012
HPCL 42095 27.77% 0.12 29632.22048 -0.429197088
Petronet LNG 35460 26.14% 0.13 3172.354669 -0.201452532
Indraprastha Gas 20307 0.35% 0.87 214.4081395 -0.026110747
Oil India 20213 17.24% 0.23 2347.698009 0.576535481

Medium Cap
Companies

Regression between Borrowings & Surplus

Market Capitalization Co-efficient of
Company (Cr.) R2 P-Value Intercept X
MRPL 12820 0.19% 0.91 5712.408423 0.056579867
Gujarat Gas 10335 52.39% 0.02 532.5069755 1.406692212
Mahanagar Gas Ltd. 9245 48.69% 0.02 19.34966528 -0.015874702

Small Cap Companies

Regression between Borrowings & Surplus

Market Capitalization Co-efficient of
2
Company (Cr.) R P-Value Intercept X
CPCL 3896 4.65% 0.61 5096.660165 -0.328341491
BPCL 860 29.36% 0.13 23530.29567 -0.250566124
Reliance 839 72.64% 0.00 26252.15253 1.430354166
Deep Industries 473 93.01% 0.00 10.7062527 0.992380989
Aban Offshore 386 70.78% 0.00 13305.66977 0.401858561
ONGC 195 0.80% 0.81 3536.461731 0.048988843
IOCL 147 5.12% 0.59 78563.08172 -0.194646631

If pecking order theory were to be followed by the Indians companies then it would be
more likely in case of large cap companies than in case of small cap companies. In
spite of negative correlation for 9 out of 16 companies, we cannot say that Indian
companies follow pecking order stringently due to low regression coefficient.

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TESTING PECKING ORDER THEORY WITH THE HELP OF
REGRESSION BETWEEN INVESTMENT UPON
BORROWINGS RATIO AND INVESTMENT UPON SURPLUS
RATIO
Independent (X variable): investment upon Surplus ratio
Dependent (Y variable): investment upon borrowings ratio

Surplus was calculated for every firm by using the formula stated previously, borrowing
have been taken from the balance sheet and investments have taken from the cash
flow (cash flow from investing activities)

With increase in company’s surplus, investment remaining constant both sides, the
ratio of investment upon surplus is supposed to fall whereas with fall in borrowings
(assuming the company follows pecking order theory and hence will go for dept
redemption or internal financing), the ration of investment upon borrowings will rise.

We run the regression test to check the validity of the above statement. If pecking
order theory were to be applicable, then the two ratios would exhibit a negative
correlation with high regression coefficient. However, on carrying out test, no such
results were obtained.

Once again, we cannot provide evidence for the existence of pecking order theory in
this case.

CONCLUSION
We carried out regression on four different pairs of variables but no strong evidence
of pecking order theory was observed. Large market capitalization companies showed
a slight tendency towards following the pecking order theory but the value of the
regression coefficient was very low hence nothing can be commented with certainty.

After carrying out the various statistical tests, we conclude that Indian companies
in oil and gas sector do not follow pecking order theory.

REFERENCE
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  Vandana Bhama, Pramod Kumar Jain, Surendra Singh Yadav, (2016) "Testing
the pecking order theory of deficit and surplus firms: Indian evidence",
International Journal of Managerial Finance, Vol. 12 Issue: 3, pp.335-350,
https://doi.org/10.1108/IJMF-06-2014-0095
 https://www.moneycontrol.com/india/stockpricequote/

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