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None of this disproves the trade-off theory. As George Stigler emphasized, theories are
not rejected by circumstantial evidence; it takes a theory to beat a theory. So we now turn to a
completely different theory of financing.
18-4 The Pecking Order of Financing Choices
The pecking-order theory starts with asymmetric information—a fancy term indicating that
managers know more about their companies’ prospects, risks, and values than do outside
investors.
Managers obviously know more than investors. We can prove that by observing stock price
changes caused by announcements by managers. For example, when a company announces an
increased regular dividend, stock price typically rises, because investors interpret the increase
as a sign of management’s confidence in future earnings. In other words, the dividend increase
transfers information from managers to investors. This can happen only if managers know
more in the first place.
Asymmetric information affects the choice between internal and external financing and
between new issues of debt and equity securities. This leads to a pecking order, in which
investment is financed first with internal funds, reinvested earnings primarily; then by new
issues of debt, and finally with new issues of equity. New equity issues are a last resort when
the company runs out of debt capacity, that is, when the threat of costs of financial distress
brings regular insomnia to existing creditors and to the financial manager.
We will take a closer look at the pecking order in a moment. First, you must appreci-
ate how asymmetric information can force the financial manager to issue debt rather than
common stock.
Debt and Equity Issues with Asymmetric Information
To the outside world Smith & Company and Jones, Inc., our two example companies, are
identical. Each runs a successful business with good growth opportunities. The two busi-
nesses are risky, however, and investors have learned from experience that current expec-
tations are frequently bettered or disappointed. Current expectations price each company’s
stock at $100 per share, but the true values could be higher or lower:
Smith & Co. Jones, Inc.
True value could be higher, say $120 $120
Best current estimate 100 100
True value could be lower, say 80 80Now suppose that both companies need to raise new money from investors to fund capital
investment. They can do this either by issuing bonds or by issuing new shares of common
stock. How would the choice be made? One financial manager—we will not tell you which
one—might reason as follows:
Sell stock for $100 per share? Ridiculous! It’s worth at least $120. A stock issue now would
hand a free gift to new investors. I just wish those skeptical shareholders would appreciate the
true value of this company. Our new factories will make us the world’s lowest-cost producer.
We’ve painted a rosy picture for the press and security analysts, but it just doesn’t seem to be
working. Oh well, the decision is obvious: we’ll issue debt, not underpriced equity. A debt issue
will save underwriting fees too.