Question

What are the assumptions and predictions of the pecking order theory? Why do empirical studies generally find in a negative abnormal stock return upon the announcement of an equity issue?

Answer 1

Introduction of Pecking Order theory

Pecking order theory of capital structure states that firms have a preferred hierarchy for financing decisions.  The highest preference is to use internal financing (retained earnings and the effects of depreciation) before resorting to any form of external funds.  Internal funds incur no flotation costs and require no additional disclosure of proprietary financial information that could lead to more severe market discipline and a possible loss of competitive advantage.  If a firm must use external funds, the preference is to use the following order of financing sources: debt, convertible securities, preferred stock, and common stock.This order reflects the motivations of the financial manager to retain control of the firm (since only common stock has a “voice” in management), reduce the agency costs of equity, and avoid the seemingly inevitable negative market reaction to an announcement of a new equity issue.

Assumptions of Pecking Order Theory

Implicit in pecking order theory are two key assumptions about financial managers.  The first of these is asymmetric information, or the likelihood that a firm’s managers know more about the company’s current earnings and future growth opportunities than do outside investors.  There is a strong desire to keep such information proprietary.  The use of internal funds precludes managers from having to make public disclosures about the company’s investment opportunities and potential profits to be realized from investing in them.  The second assumption is that managers will act in the best interests of the company’s existing shareholders.  The managers may even forgo a positive-NPV project if it would require the issue of new equity, since this would give much of the project’s value to new shareholders at the expense of the old

Capital Market Treatment of new Security Issues

The two assumptions noted above help to explain some of the observed behavior of financial managers.  More insight is gained by looking at how the capital markets treat the announcement of new security issues.  Announcements of new debt generally are treated as a positive signal that the issuing firm feels strongly about its ability to service the debt into the future.  Announcements of new common stock are generally treated as a negative signal that the firm’s managers feel the company’s stock is overvalued (i.e. earnings are likely to decline in the future) and they wish to take advantage of a market opportunity.  So it is easy to see why financial managers use new common stock as a last resort in capital structure decisions.  Just the announcement of a new stock issue will cause the price of the firm’s stock to fall as the market participants try to sort out  the implications of the firm choosing to issue a new equity issue.