Asymmetric Information and the Pecking (Dis)Order

We study the classical problem of raising capital under asymmetric information. Following Myers and Majluf, we consider firms endowed with assets in place and riskier growth opportunities. When asymmetric information is concentrated on assets in place (rather than growth opportunities), equity-like securities are more likely to be optimal. In contrast, when asymmetric information falls on growth options, debt is optimal. Intuitively, this happens because when the asset with greater volatility is less affected by asymmetric information, issuing a security with greater exposure to upside potential (such as equity) can be less dilutive than issuing a security lacking such exposure (such as debt). Our results suggest that equity is more likely to dominate debt for younger firms with larger investment needs, endowed with riskier, more valuable growth opportunities. Thus, our model can explain why high-growth firms may prefer equity over debt, and then switch to debt financing as they mature.