On the Informativeness of External Equity and Debt

According to the pecking order hypothesis, firms¡¯ sources of finance can be ranked in order of preference as (i) internal equity, (ii) debt, and (iii) external equity. In reality, however, it is not unusual that a firm seeking funds for new investment issues common stock (i.e., external equity) even in a situation where the issuance of bonds or borrowing from the bank (i.e., debt) is also available. This paper focuses on the informational aspects of external equity and debt, and gives an explanation why firms occasionally prefer external equity to debt as a source of funds. Using a simple cheap-talk model, we show that external equity can be more informative to investors than debt, thus making external equity a more preferred source of financing than debt for entrepreneurs.