Question

Which of the following M&M assumptions is violated in the pecking-order theory of capital structure?

	A.	No agency problems
	B.	No taxes
	C.	No asymmetric information
	D.	No financial distress costs

Answer 1

The pecking order theory states that due to the asymmetric information,where the managers have more information about the happenings inside the company than the shareholders, a company prefers to choose debt over equity to send a positive signal to the investors that the company is performing well . The company has a choice to choose between different sources of finance which is primarily internal earnings, debt and external equity.

The most preferred choice is internal equity, then if it is exhausted a company can raise finance through debt and if already too much debt exists than a company may raise external equity. Asymmetric information favors the issue of debt over equity as this action will generate a sense of confidence in the investors. Rational managers will raise finance through internal equity and debt rather than raise finance through external equity which might send a negative signal that the stock is overvalued and the investors will sell the stock more to bring down it's prices.

So, it violates the M&M's assumption that there is no asymmetric information.

So, the correct option is option C.