"Corporate Financing and Investment Decisions When Firms have Information that Investors Do not have: A critique."

Essay by crazydiamondUniversity, Master'sA, October 2005

download word file, 7 pages 3.0

Downloaded 233 times

This is a critique write up on A famous paper "CORPORATE FINANCING AND INVESTMENT DECISIONS WHEN FIRMS HAVE INFORMATION THAT INVESTORS DO NOT HAVE" by Myers & Majluf (1984). This write-up investigates their motivation, research methodology, and policy implication in details.

I. Introduction.

Does capital structure matter? The proposition of the famous MM's argued that the firm's value is determined solely by its real assets, not by the securities it issues. Therefore, the capital structure can be considered irrelevant to firm's value. This huge proposition has drawn interests from researchers over decades. Since we believe that, in practical world, market cannot be 100 percent perfect 100 percent of the time. Researchers have sought to explain the matter of financing by introducing frictions omitted in the original MM's model. One of the possibilities questioned by Myers and Majluf is that what would happen when information is not symmetry among each party in market? And this is the central issue they focused on the entire paper.

The idea in this study is to systematically explain the theory of pecking order which means that generally firms have preference for internal finance, debt, hybrid and equity respectively. Moreover, the authors try to explain some corporate behaviours implied form the pecking order theory such as when managers sometimes pass up valuable investment opportunities if they don't have sufficient cash in hand.

II. Literature Review.

The theory of optimal capital structure began with Modigliani and Miller (1958) proof of irrelevance of capital structure to firm's value. However, when we take into account the real world, their theory is struggling hardly to explain many of financial behaviors. One of the problems raised by Akerlof (1970) is the first attempt to address the result of asymmetric information on market. This is called lemon problem which lead to adverse...