Signalling with Debt and Equity: A Unifying Approach and its Implications for the Pecking Order Hypothesis and Competitive Credit Rationing

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 Þnance dominates equity finance. On the other hand it leads to Stiglitz & Weiss (1981) credit rationing whose consequence is that equity Þnance dominates debt finance. The paper resolves the puzzle by allowing Þrms 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.