Week 3: Pecking Order Theory of Capital Structure Flashcards
What is the pecking order theory of capital structure?
Because of asymmetric info, firms fund their investments in order of: internal finance > debt issues (if internal finance insufficient) > equity issues (LAST RESORT) –> capital structure is cumulative outcome of past pecking-order financing decisions –> no ‘optimal’ debt-to-equity ratio as each firm’s debt-equity ratio just reflects its cumulative requirements for external finance.
Why is internal finance highest on the pecking order?
Investing w internal finance/cash holdings sends no signal about firm’s true value whereas external finance is costly –> avoids issue costs & info problems completely.
Why is debt higher than equity on the pecking order?
Asymmetric info associated w equity issuances –> stock issues seen as sign of overvaluation; debt issues seen as sign of undervaluation –> e.g. stock prices may drop if stock issue announced to eliminate overvaluation –> corporate debt has less risk compared to equity because if financial distress avoided, investors receive fixed return.
How does Akerlof’s ‘market for lemons’ link to the pecking order theory of capital structure?
Asymmetric info between firm’s management (who have better info about firm’s prospects & risks) & external investors –> equity issuance may signal to mkt insufficient internal funds or debt capacity to finance its investments –> can be perceived by investors as signal of adverse selection as in Akerlof’s model –> investors may demand discount on price of equity or demand risk premium to compensate for uncertainty about firm’s quality or riskiness of its investment opportunities –> undervaluation –> firms may be reluctant to pursue equity financing.
