According to the Pecking Order Theory of Stewart Myers, what is the pecking orde

ID: 2782113 • Letter: A

Question

According to the Pecking Order Theory of Stewart Myers, what is the pecking order that managers should follow in raising capital for investment? What exactly is the “cost” that Myers argues that managers should consider in raising capital, and why this is the relevant concern? Roughly, describe the magnitudes of these costs associated with the issue of various types of securities in the pecking order. Describe the Lemon Problem, advanced by George Akerloff, when there is informational asymmetry between two parties. When there are informational inefficiencies in markets, Myers argues that corporate actions send important signals to market participants. Describe the signals that stock issues and bond issues might send to markets about the firms’ prospects and explain why. Correspondingly, how do markets react to announcements of these two types of security issues?

Explanation / Answer

The pecking order that managers should follow in raising capital is as follows:

Retained earnings is preferred over debt which is preferred over equity. Managers should always prefer internal funding or retained earnings as a source of finance. Only when internal resources are not available that it should go for external sources. In external sources, debt is preferred over equity as raising equity capital leads to issue of shares and dilution of the company's ownership. Alternatively, the cost of equity is higher as the investor expects a higher return for taking a higher risk than purchasing debt. In debt short term should be preferred over long term debt.

The reason for following this order is the cost of asymmetric information. It is also referred to as the adverse selection problem.

It occurs when the buyer and seller of a security have different information. Thus, the kind of security that the issuer/ seller issues is assumed to be an indicator of the company’s condition. Investors believe that the managers have some information that they do not.

For example, (a) if a firm issues equity shares to raise capital from the market, it indicates that the managers believe that the company is overvalued and managers are trying to take an advantage of this overvaluation. Thus, an investor will assign a lower value to the new equity issue. Consequently, management will have to forego ownership at a lower price, which is not preferred.

In case of (b) new debt being issued, investors feel that the management perceives the company's share price to be undervalued. Also it sends a signal that the company's future cash flows are going to be able to meet the debt obligations. Thus, investor's interpret the issuance of new debt more positively than in the case of issuance of new equity. The impact on share price is more or less flat. In other words, investors are less adverse to selecting debt than equity.

This problem of asymmetric information is known as the lemons problem. Adverse selection problem leads to a lower willingness to pay. Buyers are willing to pay only average prices for a share. Thus, selling equity is more attractive for bad firms than good firms. Prices may keep falling if only bad firms issue equity, and may lead to a complete breakdown of the market.

The signals and their reactions have been mentioned above.

Signal

Reaction

Equity Issue

Share overvalued

Share price goes down

Debt Issue

Share undervalued

Share price remains more or less flat