Question

Capital structure is the proportion of debt and equity financing of a firm. It indicates how
the company operation of a business is financed. There are several theories that have
been discussed in the literature regarding capital structure. Compare and contrast Pecking
Order Theory and Asymmetric Information Theory.

the answer should 400 words

Asmah Enterprise is a business dealing in pain reduction medication. It has a required
return on its assets of 18%. It can borrow in the debt market at 10%. If there are no taxes
and M&M's proposition II holds, calculate the cost of equity if there is 50% equity
financing and 50% debt financing.

Answer 1

What is the Pecking Order Theory?

The Pecking Order Theory, also known as the Pecking Order Model, relates to a company’s capital structure. Made popular by Stewart Myers and Nicolas Majluf in 1984, the theory states that managers follow a hierarchy when considering sources of financing.The pecking order theory states that managers display the following preference of sources to fund investment opportunities: first, through the company’s retained earnings, followed by debt, and choosing equity financing as a last resort.

The pecking order theory arises from the concept of asymmetric information. Asymmetric information, also known as information failure, occurs when one party possesses more (better) information than another party, which causes an imbalance in transaction power.

Company managers typically possess more information regarding the company’s performance, prospects, risks, and future outlook than external users such as creditors (debt holders) and investors (shareholders). Therefore, to compensate for information asymmetry, external users demand a higher return to counter the risk that they are taking. In essence, due to information asymmetry, external sources of finances demand a higher rate of return to compensate for higher risk.

In the context of the pecking order theory, retained earnings financing (internal financing) comes directly from the company and minimizes information asymmetry. As opposed to external financing, such as debt or equity financing where the company must incur fees to obtain external financing, internal financing is the cheapest and most convenient source of financing.

When a company finances an investment opportunity through external financing (debt or equity), a higher return is demanded because creditors and investors possess less information regarding the company, as opposed to managers. In terms of external financing, managers prefer to use debt over equity – the cost of debt is lower compared to the cost of equity.

The issuance of debt often signals an undervalued stock and confidence that the board believes the investment is profitable. On the other hand, the issuance of equity sends a negative signal that the stock is overvalued and that the management is looking to generate financing by diluting shares in the company.

When thinking of the pecking order theory, it is useful to consider the seniority of claims to assets. Debtholders require a lower return as opposed to stockholders because they are entitled to a higher claim to assets (in the event of a bankruptcy). Therefore, when considering sources of financing, the cheapest is through retained earnings, second through debt, and third through equity.

Example of the Pecking Order Theory

Suppose ABC Company is looking to raise $10 million for an investment project. The company’s stock price is currently trading at $53.77. Three options are available for ABC Company:

1. Finance the project directly through retained earnings;
2. One-year debt financing with an interest rate of 9%, although management believes that 7% is the fair rate
3. Issuance of equity that will underprice the current stock price by 7%.

What would be the cost to shareholders for each of the three options?

Option 1: If management finances the project directly through retained earnings, the cost is $10 million.

Option 2: If management finances the project through debt issuance, the one-year debt would cost $10.8 million ($10 x 1.08 = $10.8). Discounting it back one year with the management’s fair rate would yield a cost of $10.09 million ($10.8 / 1.07 = $10.09 million).

Option 3: If management finances the project through equity issuance, to raise $10 million, the company would need to sell 200,000 shares ($53.77 x 0.93 = $50, $10,000,000 / $50 = 200,000 shares). The true value of the shares would be $10.75 million ($53.77 x 200,000 shares = $10.75 million). Therefore, the cost would be $10.75 million.

As illustrated, management should first finance the project through retained earnings, second through debt, and lastly through equity.

Key Takeaways of the Pecking Order Theory

The pecking order theory relates to a company’s capital structure in that it helps explain why companies prefer to finance investment projects with internal financing first, debt second, and equity last. The pecking order theory arises from information asymmetry and explains that equity financing is the costliest and should be used as a last resort to obtain financing.

Theory of Asymmetric Information

The economic theory of asymmetric information was developed in the 1970s and 1980s as a plausible explanation for market failures. The theory proposes that an imbalance of information between buyers and sellers can lead to market failure.

Market failure, to economists, means an inefficient distribution of goods and services in a free market, in which prices are determined by the law of supply and demand.

Understanding Asymmetric Information Theory

Three economists were particularly influential in developing and writing about the theory of asymmetric information: George Akerlof, Michael Spence, and Joseph Stiglitz. The three shared the Nobel Prize in economics in 2001 for their contributions.

Akerlof first argued about information asymmetry in a 1970 paper entitled "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism." In this paper, Akerlof asserted that car buyers possess different information than car sellers, giving the sellers an incentive to sell goods of poor quality without lowering the price to compensate for the inferiority.

Akerlof uses the colloquial term lemons to refer to bad cars. He argues that buyers often do not have the information to distinguish a lemon from a good car. Thus, sellers of good cars cannot get better-than-average market prices for their products.

This argument is similar to Gresham's law about money circulation, which argues that poor quality money triumphs over better money. That theory has faced considerable opposition.

The Hiring Gamble

Michael Spence added to the debate with a 1973 paper "Job Market Signaling." Spence maintains that new hires are uncertain investments for any company. That is, the employer cannot be certain of a candidate's productive capabilities. Spence compares the hiring process to a lottery.

In this case, Spence identifies the information asymmetries between employers and employees.

It was Stiglitz, however, who brought information asymmetry to mainstream acceptance. Using a theory of market screening, he authored or co-authored several papers, including significant work on asymmetry in the insurance markets.

Through Stiglitz's work, asymmetric information was placed into contained general equilibrium models to describe negative externalities that price out the bottom of markets. For instance, the health insurance premium needed to cover high-risk individuals causes all premiums to rise, forcing low-risk individuals away from their preferred insurance policies.

Empirical Evidence and Challenges

Market research over the years has called into question the existence or the practical duration of asymmetric information causing market failure. Real-life analysis has been offered by economists including Erik Bond (for the truck market, in 1982), Cawley and Philipson (on life insurance, in 1999), Tabarrok (on dating and employment, in 1994), and Ibrahimo and Barros (on capital structure, in 2010).

Little positive correlation between insurance and risk occurrence has been observed in real markets, for instance. One possible explanation is that individuals do not usually have expert information about their own risk types, while insurance companies have actuarial life tables and significantly more experience in predicting risk.

Challenging the Facts

Other economists, such as Bryan Caplan at George Mason University, point out that not everyone is in the dark in real markets. Insurance companies aggressively seek underwriting services, for example.

Caplan also suggests that models based on the ignorance of one party are flawed, given the availability of information from third parties such as Consumer Reports, Underwriters Laboratory, CARFAX, and the credit bureaus.

Economist Robert Murphy suggests that government intervention can prevent prices from accurately reflecting known information, which can cause market failure. For example, a car insurance company might be forced to raise all premiums equally if it cannot base its price decisions on an applicant's gender, age, or driving history.