Question

4. 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?

Answer 1

The pecking order that managers should follow is:

1. Internally generated funds: this would be the best source it will give positive signal to the investors.

2. Debt : as the investors considers it as good signal because it shows the company's ability to repay the principal.

3. Equity: least preferred source as it will dilute present shareholders stake. And it shows that company is not able to get cheap debt finacing that is why it is opting for equity.

The cost that is relevant in capital structure is cost of capital I.e. thd capital has a weighted cost which would serve as a benchmark to continue the business or not when compared with IRR of business.

Magnitudes of these costs are:

1. Internal funds: cost of equity

2. Debt = cost of debt (1-t)

3. Equity = cost of equity.

Signals that are sent to the market:

Debt issue= positive signal because investors take it as company's ability to pay the principal.

Equity issues: sends negative signal to investors as they are issued as a expensive source of financing and when companies issue equity that dilutes the existing shareholdrrs rights.

When debt issue arises: investors take it as positive signal and start investing in Debt.

When equity issues arises: it is a negative signal and investors don't invest in equity because it dilutes their earnings.