Proceedings

well-defined debt-to-value ratio. There is a distinction between internal and external
equity.
The companies prefer internal financing they target dividends given investment
opportunities, then chose debt and finally raise external equity (Myers & Majluf,
1984). The pecking order was traditionally explained by transaction and issuing costs.
Retained earnings involve few transaction costs and issuing debt incurs lower
transaction costs than equity issues. Debt financing also involves a tax - reduction if
the company has a taxable profit. To give a theoretical explanation for the pecking
order phenomena several authors invoked asymmetric information. The signaling
model leads to a pecking order concept of capital structure, where retained earnings
are preferred to debt and debt is preferred to new equity. The signaling model showed
that only low profit type companies would issue equity in a separating equilibrium.
Rational investors foresee this and demand a discount in Initial Public Offerings
(IPO). This discount is a cost of raising equity that will be borne by the internal
stockholders. Debt signals to the capital market that the issuing company is a high
performance company.
Asymmetric information between old and new investors, and managers and investors
incite to signaling games where the amount of debt and the timing of new issues is
viewed as a signal of the performance of the company. The idea underlying the
signaling models is that stockholders or managers signal private information to the
security market in order to correct the market’s perception of excellence.
The pecking-order theory explains why the bulk of external financing comes from
debt. It also explains why more profitable companies borrow less: not because their
target debt ratio is low in the pecking order they don't have a target but because
profitable companies have more internal financing available. Less profitable
companies require more external financing, and consequently accumulate more debt.
The pecking-order theory cannot explain why financing tactics are not developed to
avoid the financing consequences of managers' superior information. For example,
suppose that any special information available to the manager today will reach
investors within the next year. The manager cannot know today whether he or she will
view the future price as too high or too low.
Myers and Majluf consider a very simple setting, where the company's only financing
choice is debt vs. equity. The pecking order does not necessarily hold in more
complicating settings, for example when the company also chooses between straight
and convertible debt.
1.3. Tests of the trade-off and pecking order theories
The trade-off theory implies a target-adjustment model meanwhile pecking-order
theory says that the debt ratio depends on the company's cumulative financial deficit
its cumulative requirement for external financing. Shyam-Sunder and Myers tested
these time-series predictions on a panel of 157 companies from 1971 to 1989. They
found statistically significant support for both the pecking order and a targetadjustment
specification of the trade-off theory. The trade-off theory, expressed as a
target adjustment model, was "consistent with" financing choices driven solely by the
pecking order. The pecking order generates mean-reverting debt ratios when capital
~ 810 ~