Game theory and Pecking order

Only recently did I come across game theory and all its applications. Nowadays I see it everywhere. Pecking order is an application I read recently.

Pecking order is a theory of corporate structure. It says firms follow an order for pecking money- internal finances first, then debt and issue shares as a last resort. Debt is always preferred over equity, no matter what.

The theory assumes asymmetric information- managers know more than investors. This is easier to see. When a big announcement comes, share price spurts. If investors knew as much as managers, this would not happen. Investors would’ve bought all shares in anticipation.

When manager thinks shares are undervalued, he should prefer debt- why issue more shares when they are traded at below fair value? On the contrary, they prefer equity when shares are overvalued- make hay while the sun shines.

Why then do they prefer debt always? The answer lies in game theory, the theory of choices where decisions players make affect one another. Suppose the firm issue equity to raise money (to make hay). Investors anticipate trouble and share prices fall, sometimes more than what it should. On the other hand, when debt is issued, share prices rise.

Now manager anticipates this behavior and considers he is better off issuing debt, even if shares are overvalued. Why not let bad news go to investors through other channels? So he issues debt no matter what. But does share prices rise? Not always. Why? Investors anticipate manager’s behavior, so they have no clue as to whether shares are over/under valued.

The conclusion of game theory reinforced in this example is this: A system where rational players operate rapidly evolves to a point where no one is better or worse off.

Blogger’s dilemma

Let’s cross-link our blogs, my friend tells me. What does that mean, I ask him. You put my link on your blog and me, you. So what happens? We will get each other’s readers. It increases our hits.

Confused, I ask him. Increase hits? Why should we increase hits? If we increase hits, it means our blog is popular, he explains. Hey, I can understand what it means, but is that the reason why we blog, to become popular? He seems exasperated. Well, hmmm, if you don’t want popularity, why don’t you have a personal diary instead? I couldn’t think of an answer, and said as much.

We moved on to other things. After a while I tell him, I don’t blog regularly. How will I increase hits, even if I crosslink? Well, if you want to become popular, you have to blog atleast once in two days. Put your link in orkut groups, chat messages and mailgroups…learn to network, he advises me. I thank him for the enlightening discussion.

A blogger’s dilemma is this- he blogs because he wants others to read it, but the more readers he gets, the more pressure he is under…what can I change to make this post more readable?, This is interesting, may be posting this will get me more hits, etcetera. Suddenly, there are no uninhibited feelings, ideas, and thoughts; only conformity.

So what is my final take? I write blogs because I do want others to read it. But I don’t like to push it. I don’t like to worry about losing readership just because I don’t blog regularly.

When someone stumbles onto my blog, reads it and puts a comment ‘nice one’, I do feel pleased. In fact I used to get a lot of 'nice ones' before. Unfortunately they were invariably follwed by messages like how to enlarge your, well, stock returns.

How about Casio sponsoring Exams?

Mid term exams of term3 started today. Financial management II. I could have taken the exams last term and still performed the same way. There was nothing conceptual, all calculations.

NPV (net present value) is the most basic of all financial calculations; and the most intensive. There is supposedly a table which simplifies the calculation, but the professor thought we had enough time. So there we were, doing NPV for 20 years for different rates, by trial and error. Imagine using both hands on calculator

May be we could have casio sponsoring our exams. We can even have commercial breaks ‘You will solve the next question after these messages from our sponsor’. The way papers are being set, that looks a distinct possibility.