Asymmetric Information Theory: The Pecking Order Theory By Myers And Majluf

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In 1984, Myers and Majluf firstly introduced the pecking order theory, which is based on the asymmetric information between people inside and outside the firm and the adverse selection problems resulted from the information asymmetry. The pecking order theory does not estimate an optimal leverage ratio as trade-off theory. However, it claims that a firm’s debt level is just a preferential order of financing options (internal or external sources) when the firm needs more funding, It is determined by the availability and cost of resources rather than follows a target debt ratio. The theory states that when a firm looks for funds to finance a new project, it will follow a preferred financing order which starts from internal funding. Firms would …show more content…
In corporate finance, asymmetric information refers to the phenomenon that managers have more information than investors about the value of a firm, how well it is doing and its growth potential. Therefore, the shareholders will base on managers’ actions to forecast the firm’s future. It is believed that managers’ actions give signal information of the firm’s status to the market. When managers believe that the firm is undervalued, they will be unwilling to issue new equity because new equity issuance leads to dilution of existing shareholders. And hence managers only decide to issue shares when they feel that the firm is overvalued. When releasing an equity issue announcement to the market, a firm sends a signal to investors that that its equity is too expensive, and it will lead to the plunge of share prices on the announcement day. Therefore the optimal decision for the firm is to begin with internal funds whenever available as this source avoids all asymmetric information problems. When the firm is out of internal funds, debt will be used because debt is considered less affected by asymmetric information than equity. Then hybrid securities such as convertible debts are the next financing sources and equity serves as the last resort. Hence, firms which are …show more content…
There is evidence proving that agency conflicts exist in firms having abundant amount of cash and overinvesting (Jensen and Meckling, 1976; Fazzari et al., 1988; Stein, 2003). In firms with agency conflict problems, managers are likely to use the available cash flows to invest in projects which may have negative NPV for their own interests following the empire-building model rather than for maximizing shareholder value (Jensen and Ruback, 1983). The empire-building may lead to over-investment issues with higher-than-expected level of free cash flow over investment opportunities (Stein, 2003). On the other hand, firms can face underinvestment problems when they have financial constraint (Kaplan and Zingales, 1995). Underinvestment due to asymmetric information may lead to the cases when some positive NPV projects are not taken into account while the management decides to invest in lower quality projects which may need external financing sources (Myers and Majluf, 1984). Hence, the main concern of shareholders is to ensure that managers run the firm with proper resources in order to maximize its value. This requires shareholders to seek a solution of the principal-agent problem. It is recommended that financing policies should be used as an efficient and economical tool for shareholders to diminish the agency problems (Grossman and Hart, 1980;

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