Understanding Asymmetric Information in Capital Structure
School
London School of Economics**We aren't endorsed by this school
Course
FM 431
Subject
Economics
Date
Dec 10, 2024
Pages
23
Uploaded by AmbassadorBravery15766
1/23Lecture 9: Asymmetric InformationInstructor: Dr. Cynthia BallochLondon School of EconomicsFM431
2/23Asymmetric informationIn many situations, information is asymmetric:▶One person knows more about what is going on than anotherAsymmetric information can lead to:1.“Adverse selection”▶Those with more information benefit more▶This worsens outcomes in general▶E.g., used cars, health insurance2.“Moral hazard”▶Imperfect information about actions or tasks▶Agents make less effort than a principal would ideally want▶E.g., agency conflictsToday’s lecture focuses on asymmetric information and capital structure.
3/23Recall: tradeoff theory of capital structureUndertake all positive NPV investments:▶Finance such investments with equity (or issue equity to repurchasedebt in the absence of such investments) when leverage rises abovethe target capital structure▶Finance such investments with debt (or issue debt to buy back stockshares or pay dividends in the absence of such investments) whenleverage falls below the target capital structure.
4/23Symmetric information and investmentXYZ’s assets in place are subject to idiosyncratic risk:▶Withp= 0.5, PV = 150 or PV = 50▶Everyone – both insiders and outsiders – shares these beliefs▶They are “symmetrically informed”▶Uncertainty resolved in one yearConsider a new investment project:▶Discount rate: 10%, Investment outlay: 12▶Safe return next year: 22→PV = 22/1.1 = 20▶NPV=−12 + 20 = 8Should XYZ undertake the project:1.if XYZ has enough cash available?2.if XYZ needs to raise external funds?
5/23Capital raising with symmetric information1.If internally financed with cash:▶Existing shareholders realize the full 8 NPV of the investment2.If XYZ issues equity to finance the project:▶Once the project is funded, the firm is worth 100 + 20 = 120▶Raise 12 by selling 10% of shares (after issue)▶Existing shareholders get 90% of 120 = 108▶Gain 8 relative to no investment3.If XYZ issues debt to finance the project:▶Issue discount bond due in one year with face value 13.2.▶Once project is funded, at least 22 cash next year, so bond is risk-free▶Bond raises 13.2/1.1 = 12, enough to finance the project▶Existing shareholders get 100 + (22−13.2)/1.1 = 108▶Gain 8 relative to no investment
6/23Indifference under symmetric informationThis example suggests that firms should be indifferent between:▶External and internal financing (i.e., no need to save)▶When financing externally, debt and equity financingIrrelevance of internal vs external financing (in the example) comes from:▶the fact that existing shareholders (represented by managers) andnew shareholders agree on the value of financial claims▶and, of course, that there are no frictions such as taxes, transactioncosts, financial distress, etc.Sources of disagreement:▶Asymmetric information▶Inefficient markets
7/23Aggregate sources of funding for capex▶More than 70% of capex is funded from retained earnings▶U.S. firms tend to repurchase equity and issue debtSource: Federal Reserve Flow of Funds; Berk and DeMarzo.
8/23Pecking order theory of capital structureIn practice, companies follow a “pecking order” in which they financeinvestment:▶first with internally generated funds▶then with debt▶and finally with equityThey may even forgo positive NPV investments because of reluctance toraise additional external financing
9/23Asymmetric information, good firmAssume now that:▶Managers know XYZ’s existing assets to be worth 150▶The market does not know if they are worth 150 or 50,assignsp= 0.5 to each possibility▶No asymmetric information about the new projectShould XYZ undertake the project:1.if XYZ has enough cash available?2.if XYZ needs to raise external funds?
10/23Asymmetric information, good firm1.Internal financing: as before, existing shareholders gain 82.Equity financing:▶Firm valued by the market at 120 (i.e., 100 + 20)▶Raise 12 by selling 10% of shares▶Existing shareholders get 90% of 150 + 20⇒153.▶Gain only 3 on top of 150 if they did not invest▶10% shares: Sold for 12 but really worth 10% of 170⇒17▶8 gain on investment - 5 loss from underpricing = 33.Debt financing:▶Raise 12 and repay 1.1×12 = 13.2 next year▶Existing shareholders get the full 8 because:150 + (22−13.2)/1.1 = 158Good firms (those with assets in place worth 150) will not want to issueequity but will prefer to finance with debt.
11/23Signaling theory of debtIn this example, debt sends a signal that the firm is “good”▶But, the new project is risk-free so the debt is risk-free▶No possibility or costs of financial distressSuppose there are large (reputational) costs of financial distress:▶Managers could borrow up to 50▶Suppose instead that the new project
12/23Asymmetric information, bad firmAssume instead that:▶Managers know XYZ’s existing assets to be worth 50.▶The market does not know if they are worth 150 or 50, assignsp= 0.5 to each possibilityShould XYZ undertake the project:1.if XYZ has enough cash available?2.if XYZ needs to raise external funds?
13/23Asymmetric information, bad firm1.Internal financing: as before, existing shareholders gain 82.Equity financing:▶Firm valued by the market at 120 (i.e., 100 + 20)▶Raise 12 by selling 10% of shares▶Existing shareholders get 90% of (50 + 20)→63▶They gain 13 on top of 50 if they did not invest▶10% shares: Sold for 12 but really worth 10% of 70 = 7▶8 gain on investment + 5 gain from overpricing = 133.Debt financing:▶Raise 12 and repay 1.1×12 = 13.2 next year▶Existing shareholders get exactly 8 because:50 + (22−13.2)/1.1 = 58Thus, the bad firm will prefer equity financing!
14/23Asymmetric informationImplications:1.Good firms prefer debt to equity2.Bad firms prefer equity to debtOutside investors understand these incentives (efficient markets):▶Infer/conclude that any equity issues are bad firms▶In the example, equity issuance reduces total market value of equity▶from 100 = 0.5×150 + 0.5×50 before the new project▶to 70: 50 of assets in place + 20 of new investment▶Drop in equity value of the firm is accompanied by an increase in thenumber of shares (due to equity issuance), so the share price dropsas well
15/23How do markets react to equity issuances?Stock prices tend to rise (relative to the market) before an equity issue isannounced. Upon announcement, stock prices fall on average.Source: Lucas and McDonald, 1990. “Equity Issues and Stock PriceDynamics,” Journal of Finance 45: 1019-1043.
16/23How do markets react to issuances of other securities?1.Equity issues are bad news▶Signaling firm is overvalued▶Signaling the firm is afraid to issue debt in fear of going bankrupt2.Debt issues are neutral or good news▶Debt is less likely to be undervalued▶Debt may signal positive information (signaling theory of debt)▶Little or no effect empirically (Dann and Mikkelson, 1984)3.Share repurchases are good news▶Signaling that shares are undervalued▶Signaling that profits will be high in the future▶Signaling that the firm will not waste excess cash▶Ikenberry, Lakonishok, Vermaelen, JFE (1995)Without uncertainty and information asymmetries, equity sends no signal▶Issue equity is after information releases (earnings, IPO roadshow)
17/23Safe debt versus equityMarket value of safe debt is independent of information asymmetries:▶Cash flows to safe debt are insensitive to variations in firm cash flows▶Managers and outside investors (the market) assign the same valueto safe debt and it is fairly priced, i.e., no underpricing.By contrast, with asymmetric information, managers and the market willnot always assign the same value to equity claims:▶Since equity holders are residual claimants, cash flows to equityholders are sensitive to variations in firm cash flows▶When managers know more than outsiders, outsiders will be(rationally) suspicious of why managers are issuing equity▶This is what leads to underpricingMarket value of risky debt depends on information:▶Need to account for underpricing, costs of financial distress▶Equity may dominate debt in some cases
18/23Value depends on financingInternal vs. External Finance▶For existing shareholders, the same project is worth more withinternal than external financingDebt vs. Equity Financing▶For existing shareholders, the same project is worth more with debtthan equity financing (unless already highly leveraged)Pecking order implies that when funding their investment projects, firms:1.Prefer to use retained earnings2.Then borrow from debt markets (unless already highly leveraged)3.As a last resort, issue equity
19/23Asymmetric information and capexIn the ongoing example, suppose investment outlay is 18 not 12▶NPV=−18 + 22/1.1 = 2▶Firm valued by the market at 120 (i.e., 100 + 20)▶Raising 18 requires selling 15% of shares (after issue)▶Existing shareholders get 85% of 150 + 20→144.5▶They lose 5.5 relative to 150 if they did not invest▶Another way to see this:▶Loss due to under-valuation 15% of 170−120→7.5▶Exceeds the project’s value of 2XYZ will not issue equity to fund the project, even if it did not haveaccess to debt markets
20/23Investment depends on financingSome projects will be undertaken only if funded internally or withrelatively safe debt but not if financed with risky debt or equity▶Information asymmetries can lead companies to “distort” theircapital budgeting by underinvesting▶Companies with less cash and more leverage will be more prone tounderinvest▶This links the RHS and LHS of firms’ balance sheets, even when thecompany is not financially distressed
21/23Excess cashGood investment policy requires good financial policy:▶Two rationales for companies hoarding cash▶Projects are more valuable when financed internally;▶Internal funds can be key for the project to go ahead at all▶Firms may want to save cash in good times so as to be lessconstrained in bad times▶Excess cash is a complicated concept and there may be disagreementabout how much cash is “excess” for a given corporation
22/23Pecking order and capital structurePecking order implies a negative link between profitability and leverage▶Firms will use cash when available, and otherwise use debt▶High cash-flow firms▶Don’t need to raise external finance▶Existing debt matures over time▶Leverage ratio decreases▶Low cash-flow firms▶Need to raise external finance▶Reluctance to raise equity, so use debt▶Leverage ratio increasesFirms’ leverage ratios result from incremental financing decisions:1.Depends on managers’ beliefs about firm underpricing/overpricing2.Capital structure thus depends on past market conditions3.Capital structure can move around a lot
23/23Summary and implicationsIn this lecture:1.Asymmetric information can explain the pecking order of financing2.Capital structure may move around based on market conditions3.Explains why firms sometimes accumulate lots of cashHowever,▶Agency problems are broader that this▶Shareholder classes, parent companies and subsidiaries, etc.▶Role and limitations of contractsThis week’s case: NEC Electronics