Question

By Definition, the pecking order Theory states that firms prefer to issue debt rather than equity if internal finance is insufficient, e.g. due to assymetric information and related (mis)Interpretation by Investors.

What does "assymetric Information and Investor misinterpretation actually mean in this context?" I would be very greatful for a thoroughly explained answer.

Answer 1

The pecking order theory states that due to asymmetric information , debt is preferred over external equity.

Asymmetric information means that the investors of a company are not provided with the complete and accurate information about the company, It is believed that the investors and the management of a company tend to have the same information, but in reality the management has more information,when managers are better informed about investment opportunities than the investors a company's share price is penalized when they raise funds through external equity. So, a company seeks through the safest funds first, before resorting to external means of financing.

Due to this asymmetry, internal financing is the most safe form of raising finance, then debt as raising debt reduces the information asymmetry. This information asymmetry seems to stem from risky securities. It can be reduced by means of a hierarchical financing as defined by the pecking order theory.