15. What is the pecking-order theory, and what facts does it seem to explain better than...

15. What is the pecking-order theory, and what facts does it seem to explain better than the trade-off model does?

Expert Solution

The pecking order theory postulates that companies prefer internal financing first, then debt and lastly equity.

The theory is based on the inherent information asymmetry surrounding companies.

Managers do have far better information of the future prospects and risks associated with investments than the public. This prompts them to choose:

*internal financing when they are confident of the prospects of the projects they have

*supplement internal financing with debt, when internal financing is not enough. One other reason for issuing debt is that the board feels the share is undervalued.

*Equity, when the managers are not confident of the projects they have and they feel the share is overvalued.

This also prompts investors to feel positive when a firm issues debt and circumspect when a firm issues equity; the signalling effect.

In comparison with the trade off theory, the pecking order theory highlights the effect of information asymmetry on the choice of the source of finance.

jeff jeffy answered 2 years ago

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