Question

What is asymmetric information? how does it affect the prioritization of financing sources under the pecking order hypothesis?

Answer 1

Asymmetric Information is a condition when one party possesses a higher amount of information than the other party. For example: A teacher may have more knowledge of a subject matter and its scope than his students. A stock broker may have greater knowledge than his investors. A manager may have more knowledge about company growth, plans and future goals than equity shareholders. This concept of asymmetric information is also known as information failure.

The pecking order hypothesis works upon the ground of asymmetric information. According to it, management of a company knows more than the external investors (debt holders or equity holders) Therefore, there exists a pecking order for financing of the new projects.

Firstly, a firm would try to finance itself through internal financing or retained earnings in order to minimize information asymmetry. Apart from it, if a company has to finance an investment opportunity through external financing (equity or debt) , a higher return is expected from them because creditors and investor possess less information regarding the company against the management of it.

Therefore, in terms of financing, a firm may have a preference of financing in the order as following:

1st Preference to internal financing or retained earning

2nd preference to debt investor since cost of debt is lower than cost of equity

3rd preference to equity investor i.e. least preference because issuance of equity sends a negative signal that the stock is overvalued and the management wants to finance by diluting shares in the company. Therefore, equity holders do not get ready to invest on the higher prices.