7- 1 ECON 4560, Anton Miglo Lecture 7: Asymmetric information and signalling with capital structure...

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ECON 4560, Anton Miglo

Lecture 7: Asymmetric information

and signalling with capital structure choice

Anton Miglo

Fall 2008

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Topics

Insiders and outsiders Information manipulations and credible

signalling Pecking-order theory Signalling by “risk-bearing” Additional readings: GT ch. 19

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Insiders and Outsiders

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Asymmetric Information Problem

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Information Disclosing and Information Manipulation

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Adverse Selection: Market for Lemons

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ExampleTwo periods. The firm will operate only once in period 2 and then be liquidated.

There is no discounting.

There exist 12 million shares outstanding.

The firm has assets worth $100 million in period 1 and needs to raise $70 million for a project, which will pay $90 million.

The cash flow of the firm in period 2 is $190 if the investment is made, and $100 if it is not.

If the entrepreneur had enough money to pay for the new project he would have done so.

Using equity will be problematic if there is asymmetric information about the real value of assets in place and the value of the new project.

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General ModelTwo periods. The firm will operate only once in period 2 and then be liquidated. There is no discounting.

The firm has assets X in period 1 and needs to raise B for a project which will pay R>B.

The cash flow of the firm in period 2 is X+R if the investment is made, and X if it is not.

If the entrepreneur had enough money to finance the project, he would have done so.

He could issue debt. Since R>B the debt would be risk free. Outside investors would have no problem buying the debt and nothing would be learned about X, but it would not matter. (the same as inside financing)

Using equity will be problematic if there is asymmetric information about X.

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Pecking-order Theory

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Signalling by “risk-bearing”

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Signalling by “risk-bearing”• project net return R=N(θ,σ²); ∙ • θ is the entrepreneur's private information;• investors are risk neutral;• The entrepreneurs’ expected utility: Eu(w)=Ew-1/2ρσ²w.• two types of firms (equally probable)

Expected profit

Variance

Type 1 100 100

Type 2 200 100

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Patterns of Corporate Financing

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Debt Ratios for some IndustriesIndustry Debt to Value Ratio Internet .0218Educational Services .0224Drugs&Cosmetics .0907Instruments .1119 Metal Mining .1347Electronics .1579Machinery .1957Food .2056Construction .2384Petroleum Refining .2436Chemicals .2544Apparel .2603 Motor Vehicles Parts .2714Paper .2895 Textile Mill Products .3257Retail Dept Stores .3433 Trucking* .3730 Steel .3819Telephone* .5150 Elec. & Gas Utilities* .5309 Airlines* .5825

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Implications

a See Leland and Pyle (1997) and Myers and Majluf (1984).

bSee Miller and Rock (1985).

cSee Ross (1977)

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Stock Market Response to Pure Capital Structure Changes

Security Issued

Security Retired

Two-Day Announcement Period

Return

Leverage Increased

Stock Repurchase Debt Common 21.9%

Exchange offer Debt Common 14.0%

Exchange offer Preferred Common 8.3%

Leverage reduced

Exchange offer Common Debt -9.9%

Security Sales Common Debt -4.2%

Conversion-forcing call Common Convertible -0.4%

Conversion-forcing call Common Preferred -2.1%

7- 1 ECON 4560, Anton Miglo Lecture 7: Asymmetric information and signalling with capital structure...

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