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Pecking over Finance

12/16/2009 --

Ross professors merge the fields of corporate finance and market microstructure to find evidence that supports the "pecking order."

ANN ARBOR, Mich. — One of the biggest decisions for any chief financial officer is finding the optimal capital structure for the firm. Is the company best served by issuing stocks? Or is it best to raise capital via bond debt, which is less sensitive to the markets?

The "pecking order" theory says that firms should use internal cash reserves first, then corporate debt. They should issue equity only as the last resort. According to the theory, firms that are relatively unknown to the market — or aren't fully understood — adhere to this pecking order when making capital structure decisions. This information gap is known as information asymmetry. For example, stock markets have punished the price of a seasoned equity offering (SEO) when the company issuing shares isn't fully understood.

Skeptics question the theory, as few studies have found strong evidence to support it. But Ross finance professors Sreedhar Bharath and Paolo Pasquariello went about testing its tenets in a new way. They found its basic assumption holds up, though it doesn't fully explain all capital decisions.

Their paper, "Does Asymmetric Information Drive Capital Structure Decisions?," synthesizes two fields of financial study — market microstructure and corporate finance. When brought together, they provide insights on firmsí capital structure decisions — backed by more robust data — that can serve as a guide for corporate CFOs.

"This is controversial because much of the recent literature dismisses the pecking order theory as not supported by the data," Pasquariello says. "But we're bridging two fields that normally don't talk to each other and we show that market microstructure insights can be useful to corporate finance."

Previous studies have tested pecking order theory predictions by using firm characteristics — such as size, growth opportunities, or tangibility of assets — as measures of information asymmetry. Pasquariello and Bharath approached it differently, testing the core assumption of the theory — that the information gap determines capital structure decisions. They also used stock market data capturing that information gap — bid-ask spreads, for instance — to identify the kinds of companies where information asymmetry is more severe and the theory is more likely to apply. For the most part, those tend to be companies seeking to raise capital in an environment where the market lacks the kind of information on the firm that management possesses.

By using seven different measures of information asymmetry, Pasquariello and Bharath were able to divide publicly traded companies into groups that experienced this information gap and those that didn't. They found that companies in the group with the highest scores for information asymmetry issued 30 percent more debt than companies in the group with the lowest scores.

"Where this asymmetry is the highest, it seems to offer a good explanation of capital structure decisions, although it's not the sole determinant," says Bharath, recently named the Bank One Corporation Assistant Professor of Finance at Ross.

He and Pasquariello say their study supports a modified pecking order theory, one that explains firms' capital decisions when the conditions are right — for example, when the firm needs money and when the market data shows a clear pattern of information asymmetry.

By confirming the pecking order theory's core assumptions, the work can help inform those working in corporate finance. Companies with information asymmetry and in need of capital tend to issue debt in the form of bonds and secured loans rather than testing the stock market. This is an important insight for a chief financial officer planning to raise capital for a firm.

The two professors study different financial disciplines — Bharath corporate finance and Pasquariello market microstructure — but met in a class at New York University. They later talked about doing a study together that would bridge the two fields.

"The biggest leaps we have seen in past years are when fields have merged with each other," Pasquariello says.

—Terry Kosdrosky

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847,