Implication:
Firms should be indiferent between internal and external fnancing (no need to
save)
A frm needing external fnancing, which is above its static optimum leverage level
will always issue equity to fnance the investment.
In practice:
Companies follow a pecking order in which they fnance investment:
o First with internally generated funds
o Then with debt
o And fnally with equity
They may even forgo positive NPV investments because of reluctance to raise
additional external fnancing.
The irrelevance of internal vs. external fnancing comes from the fact that existing
shareholders and new shareholders agree on the value of fnancial claims and
there are no frictions (e.g. taxes, transaction costs, etc).
However, in reality, frms are not indiferent between internal and external
fnancing because there is a source of disagreement, such as:
o Inefficient markets (e.g., taxes and fnancial distress costs????)
o Irrational managers
o Managers with more information than investors (Asymmetric
Information)
ASYMMETRIC INFORMATION
Helps us to understand:
o Why the pecking order?
o How does D/E ratio evolve overtime?
o Can it make sense to stray from the static optimum?
o Are there good and bad times to issue equity?
o What is the role of hybrid instruments (e.g., convertibles)?
Firms should be indiferent between internal and external fnancing (no need to
save)
A frm needing external fnancing, which is above its static optimum leverage level
will always issue equity to fnance the investment.
In practice:
Companies follow a pecking order in which they fnance investment:
o First with internally generated funds
o Then with debt
o And fnally with equity
They may even forgo positive NPV investments because of reluctance to raise
additional external fnancing.
The irrelevance of internal vs. external fnancing comes from the fact that existing
shareholders and new shareholders agree on the value of fnancial claims and
there are no frictions (e.g. taxes, transaction costs, etc).
However, in reality, frms are not indiferent between internal and external
fnancing because there is a source of disagreement, such as:
o Inefficient markets (e.g., taxes and fnancial distress costs????)
o Irrational managers
o Managers with more information than investors (Asymmetric
Information)
ASYMMETRIC INFORMATION
Helps us to understand:
o Why the pecking order?
o How does D/E ratio evolve overtime?
o Can it make sense to stray from the static optimum?
o Are there good and bad times to issue equity?
o What is the role of hybrid instruments (e.g., convertibles)?
