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Signalling with debt and equity: a unifying approach and its implications for the Pecking-Order hypothesis and competitive credit rationing

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  • Heider, Florian

    (UNIVERSITE CATHOLIQUE DE LOUVAIN, Institut de Recherches Economiques et Sociales (IRES) ; Belgian National Fund for Scientific Research (FNRS))

Abstract

The paper sets out to tackle the following puzzle when insiders of a firm have more information than outside investors. The insiders’ desire to sell overpriced securities creates an Adverse Selection problem leading to two contradictory results. On the one hand, it leads to Myers & Majluf (1984)’s Pecking-Order hypothesis that says that debt finance dominates equity finance. On the other hand it leads to Stiglitz & Weiss (1981)’ credit rationing whose consequence is that equity finance dominates debt finance. The paper resolves the puzzle by allowing firms to issue both debt and equity together and by having a general notion of what it is that insiders know more about. Then the Pecking-Order hypothesis and credit rationing only emerge as two, mutually exclusive, special cases. The paper shows that combinations of debt and equity can be used to credibly signal information for a wide range of parameters. Thus, it provides a generalisation of the existing financial signalling and rationing literatures and helps to explain some contradictory theoretical and empirical results.

Suggested Citation

  • Heider, Florian, 1997. "Signalling with debt and equity: a unifying approach and its implications for the Pecking-Order hypothesis and competitive credit rationing," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) 2000024, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES), revised 00 Jun 2000.
  • Handle: RePEc:ctl:louvir:2000024
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    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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