CW2 Answer

7/29/2019 CW2 Answer

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Student name : Minh Dai Nguyen

Student number: 110063077

Module: Business Economics

Tittle : Coursework 2

Number of words: 2400


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INTRODUCTION

In business, firms usually face situations when they have valuable investment

opportunities, but they do not have sufficient internal funds to undertake these

investment opportunities. To finance the investments, it is suggested that firms can

seek for external sources of funds, such as debt and equity financing. However,issuing debt or equity may have various impacts on value of the companies and

benefits of shareholders.

Myers and Majluf (1984) created the issue-invest decision model to explain several

corporate financing behaviors. In the research, the authors suggest asymmetric

information between managers and investors of the firms. Asymmetric information

cannot be conveyed costlessly to the investors so the true value of the firms and

investment opportunities cannot be known by investors. It may result in the beneficial

conflicts if the firms have to issue new equity. Myers and Majluf (1984) explained

investment behaviors of firms based on the level of firms financial slack1 and the

NPV2

of the investments. According to their analysis, firms tend to prefer internal to

external funds, debt to equity in financing the investments.

Wu and Wang (2004) extend the model of Myers and Majluf (1984) by presenting a

new variables, the private benefit of managers and insiders ownership, to explain

over- and underinvestment behaviors of firm. The new model concluded both private

benefit and insider ownership have opposing effect on the behaviors of under-and

overinvestment of the firm. Moreover, the announcement effect can be negative as

well as positive.

In this paper, my purpose is to summarize the theoretical models and results in these

two papers. I will discuss the main differences between the two papers and give my

opinions on the results and shortcoming of both theories.

1Financial slack : having a sufficient level of cash, marketable securities, and real assets that arereadily saleable2NPV: Net present value


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SUMMARIZE

MYERS AND MAJLUFS MODELS

1. Research question

Myers and Majluf (1984) answer the following question: How do asymmetric

information affect firms issue-investment decisions? Does the financial slack affect

firms decisions? What is more preferable debt or equity issue when there is

asymmetric information? What is the ex ante loss of firm value?

2.Myers and MajlufsModels:

Myers and Majluf (1984) created a three-date model to analyze the effect of

asymmetric information on firms issue-invest decision. There are three dates marked

in the model including t = - 1, t = 0 and t= +l. At the date t = - 1, the managers of the

firm share the same information with the market (investors). At t=0, the true value of

the firms asset-in-place (a) and NPV of investment opportunities (b) are revealed

only to the management. At time t=+1 the market receive information of the value ofthe firms asset-in-place and NPV of investment opportunities. The firm can place its

issue-investment decisions on those three dates. These decisions are assumed to be

based on the benefits of old shareholders. The model rules out the cases when a , b got

negative value.

The amount of investment, financial slack, and required equity , required debt issue

are denoted by I, S, E, D , respectively. Note that if equity is issued, the amount of

equity is given by E= I S. If debt is issued, the amount of debt is given by D=I-S.

The market value of firm is P if stock is not issued, P if stock is issued. V

old

is theintrinsic

3value of old shares held by old shareholders. Since management acts

based on interest of old shareholders, the issue-investment decisions made by

management must not reduce Vold

.4

The authors deduced the table below:

Information

available for :

t= -1

(symmetric

information)

t= 0

(Asymmetric

information )

t= +1

(Symmetric

information )

Managers Distributions

of

and

; S

a ,b, S a, b; remaining S,

if any

Market (investors) Distributions

of and ; SDistributions

of A and B; S;

and E (either

E= 0 or E=IS )

a, b; remaining S,

if any

3trueor intrinsic value means the pay off or what the shares would sell for, conditional on thefirms issue-invest decision.4Note that the issue-investment problem disappears if manager can costlessly convey their information

(a,b,S) to the markets, or they can force old shareholder to buy new equity. In the case of there is no

asymmetric information, issuing new equity will note reduce intrinsic value of old shares Vold

will not

be reduced. The interest of old shareholders are guaranteed.


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3. Results

In case of the firm with ample financial slack (S > I), the firm does not have to issue

equity to undertake the investment opportunity. Since slack allow firm to pursue theinvestment using internal fund, the Vold

=a+b+S , so the old shareholders are better off.

In case firm have ample slack and attempt to take advantages of issue new equity ( if

the share is overrated), it can be a strong pessimistic signal for the market. By those

reason, firms with ample slack will prefer internal funds to external funds to financing

investment opportunities.

Myers and Majluf interpret the value of Vold

by introducing numerical examples in

which issue decisions of firms are placed on different dates. In the example, Vold

are

likely to fall when the firm decide to issue equity in time t=0, t=+1 or firm issue share

in both time.

If the firm does not issue stock: Vold

= S + a ,

if it does issuing , Vold

=

( ).The old shareholders are only better off when : S+a

( ) (1)

The authors constructed the equation of the line, E+b=(S+a) (1) , which rational

divides behaviors of the firm. In graph 1, if actual value of the firm asset (a) and NPV

of the investment (b) fall into region M, the firm will issue and invest, otherwise the

firm do nothing. So the firms decisions to issue and invest depends on the relative

values of a and b. The higher the value of b is, the more likely firm is to issue andinvest. The lower the value of a is, the more attractive the issue price P.

Graph 1 : Myers and Majlufs model (1984) - issue-investment decision with

asymmetric information


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P =(M) + SP=(M) +(M) + S. 5Myers and Majluf explained, the decision to issue new equity always reduce the share

price (P>P) if there is a room not to issue equity. The decision not to issue equity

happens when a, b fall into M. Hence M is not empty. So any value of a fall intoregion M exceed P-S, so(M) > P- S . Hence P>P.

The model helps to explain why firms seem to prefer debt to equity issuing when

financing the investment. The reason is because of the higher value of Vold

the debt

issue will result (the firms act based on interest of shareholders)

Without issuing , Vold

=S+ a, with debt issue : Vold

=S+a+b-D

With equity issue : Vold

=S+a+b-E

(E and D are the gains of old shareholders by equity issue and debt issue at t = + 1)

With risk-free debt, the debt is as good as the slack, so the firm always issue risk-free

debt. If the debt issue is not risk-free, D may be positive or negative.

Galai and Masuliss option pricing framework (1976), give us | D | < | E |, D and

E is always same sign. In case of E=I

5(M) : The expected value of assets in place conditional on not issuing() (M) : The expected value of assets in place and NPV of Investment conditional on not issuing


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WU AND WANGS MODELS

1. Research question

Wu and Wangs (2004) answer the following question: How do insiders ownership

and private benefit affect issue-investment decision of firms? What are possible

announcement effects? How does insiders ownership and private benefits affect

under- as well as overinvestment.

2. Wu and Wangs theoretical model:

Wu and Wang developed the three-dates issue-investment model of Myers-Majluf

(1984). The model now has two new variables:

w: managers/insiders share ownership (as percentage of all share outstanding)

(before the issue)

c: private benefits of managers which arise in new investment

If the investment is passed up, the wealth of managers is w(a+S).The model gives the expected value of insiders, if the decision is to issue and invest,

as

()(a+b+E+S-c)+c .

The managers/controlling shareholders will prefer to issue equity and invest if :

w(a+S)


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Graph 2 : Wu and Wangs model (2004) - issue-investment decision with asymmetric

information and private benefits

The graph 3 below describes underinvestment and overinvestment behaviors of firms.

If (a,b) falls into the region M2, the firm underinvested; M3 the firm overinvested.

Graph 3 : Wu and Wangs model (2004) - underinvestment and overinvestment

behaviors

3. Results

In Myers-Majluf (1984) theory, the equity price will always drop at the announcement

of the new issue. The announcement effect cannot be positive. In the new model, Wu

and Wang found different changes in price of stock after a new issue. The

announcement effect can be negative as well as positive.


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At time t=0 , if the firm issue and invest, the equilibrium firm value is

Pis =() () If the firm do nothing: Pno= ()

At time t = -1 , investors may predict all the scenarios for time t =0 and the marketreach the equilibrium firm value as : Pb =( ) ,() - 6We deduct:

Pis - Pb = *() ( )+ *,() - ,() -+

(information about A) (information about B-c )

Scenario (A) Information

effect about A

(B) information

about B-c

(A)+(B) Announcement

effect

1 + + + +

2 + - + +

3 + - - -

4 _ + - -

5 - + + +

6 - - - -

Table 1 : Decomposition of announcement effect

In the model, the announcement effect depends on the dominant effects. If the

positive effect overwhelms, price of stock will rise (Scenario 1,2,5). Otherwise the

stock price drops. (Scenario 3,4,6)

In the new model, the loss of firm passing up good investment opportunities by doing

nothing (underinvestment) is LU=F(M2)(M2) (Similar to the old model). The newmodel predicts also the overinvestment. The ensuing ex ante loss of firm value is

LO=F(M3)(M3), which is negative.

Table 2 below gives the results of effect of c and w on loss and firm value . The

results is that both private benefit and insider ownership have opposing effect on

under-and overinvestment. Panel A shows, increasing private benefit c results in areduction in LU but an aggravation in LO, firm value increasing. Panel B shows,

increasing insider ownership w results in an increase in LU but an alleviation in LO,

firm value decreasing.

6(M+M) : the expected value of A conditional on both regions Mand M: theprobability (a,b) is in region M


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In panel C, when c is small, a higher insider ownership w results in a lower firm

value. But when c is large, the reverse is observed, a higher insider ownership w

results in a higher firm value. The authors suggest that, if a firm can freely choose c

and w , they should consider a relatively small amount of private benefits and a lower

level of insider ownership in order to maximize the firm value.

Table 2: the results of effect of c and w on loss and firm value


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DISCUSSION

Wu and Wang (2004) extent the issue-investment model developed by Myer and

Majluf (1984). Both models are based on assumption of three dates time, which

occurs when there is asymmetric information. The models examine the differentissue-investment decision of firms. Both models recognize the effects of financial

slack on issue-investment decision.

The first difference is about the assumptions. The old model is based on the

assumption that decisions are based on interest of the old shareholders. On the other

hand, the new one is based on the interest of managers/insiders. Managers of firms try

to maximum their own wealth including their entitled equity claims (insider

ownership) and private benefits derived from undertaking new projects. My opinion is

that the interest of managers increasingly affects their decisions. Since providing

interest for managers is an essential way to create incentives for managers, without

the interest, managers become less motivate, the firms fall to underinvestment. As forthe suggestion of the model, owners of firms should consider a relatively small

amount of private benefits and a lower level of insider ownership in order to

maximize the firm value.

In the first model, the firm only invest with positive NPV projects, all negative NPV

projects are ruled out, overinvestment is ruled out completely. However, in the second

one, managers may be interested in negative NPV one since it may yield higher

private benefit for managers. The second model is more convincing, since it happenedin reality. From that assumption, the consequences of the two models can be relatively

different. The stock price always falls in the old model, whereas it can fall or rise in

the new model. As for the ex ante loss of firm value, it comes from the concerns over

overinvestment as well as underinvestment in the new model, whereas it only comes

from underinvestment in the old one. Model 1 ignores positive announcement effect.

Moreover, in the first model, the authors compared the effects of debt issue and equity

issue to explain why firms prefer debt to equity issue. In the second model, debt issue

is not investigated.


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CONCLUSION

The analysis of Wu and Wang (2004) delivered significant enhancements to the

model of Myers and Majluf (1984) about corporate finance and investment behaviors

under asymmetric information. By providing new variables, including private benefits

and insiders ownership, the model now can explain over- and underinvestmentbehaviors of firms as well as the positive announcement effect.

There are still limitations in the model. There are a number of variables which are

forgone in the model such as tax, transaction cost. Besides, the model does not

examine the cost of conveying information. There are cases, firms managed to convey

some parts of their information, these cases may affect the results of our model.

Moreover, there are some potential related researches, such as the relationship

between providing incentives, compensation for managers and the value of firms.


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REFERENCE

Myers.S.C, Majluf. N. S (1984), Corporate financing and investment decisions when

firms have information that investor do not have, Journal of Financial Economics, 13,

187-221.

Wu.X, Wang.Z (2004),Equity financing in a Myers-Majluf framework with benefit of

control, Journal of corporate finance, Department of Economics and Finance, City

University of Hong Kong, 11, 915-945.

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