FIN 588 | Session 3 | Corporate Financing and Investment without Information

FIN 588 | Session 3 | Corporate Financing and Investment without Information - 1984 Stewart C. MYERS, Nicholas S. MAJLUF Summary The sources examine how asymmetric information—specifically, when managers possess superior knowledge of a firm's value compared to outside investors—affects corporate behavior. Because managers aim to protect the interests of existing shareholders, they may decline to issue new stock if the market price is too low, even if the capital is needed for valuable investment opportunities. This reluctance can result in a "financing trap" in which firms forfeit projects with a positive net present value (NPV) to avoid diluting the value of old shares. Consequently, the model suggests a pecking order for financing, where firms first rely on internal funds (financial slack), then prefer debt over equity to minimize the negative signals associated with new issues. The decision to issue equity is often interpreted by the market as a sign of overvaluation, which typically causes the stock price to fall. Ultimately, maintaining ample financial slack allows a firm to decouple its investment decisions from these information-related conflicts of interest. This situation is like a collector who refuses to sell a rare painting at a discount to fund a new acquisition; they would rather miss out on the new piece than let the current one go for less than they know it is worth.