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.