Asymmetric Information and Capital Structure in Economics

Overview of the Lecture

Advanced Corporate Finance
Jörg Stahl

Agency Costs and Trade-Off Theory

• Agency Costs and the Trade-Off Theory
• Asymmetric Information and Capital Structure

Advanced Corporate Finance
Jörg Stahl

Agency Costs and the Trade-Off Theory

• The value of the levered firm can now be shown to be
  VL =VU + PV (Interest Tax Shield) - PV (Financial Distress Costs)
  - PV (Agency Costs of Debt) + PV (Agency Benefits of Debt)

Advanced Corporate Finance
Jörg Stahl

Optimal Leverage with Taxes, Financial Distress, and Agency Costs

T* D
Value of Levered Firm, VL
VL
Too Little Leverage
Lost Tax Benefits
Excessive Perks
Wasteful Investment
Empire Building
Too Much Leverage
Excess Interest
Financial Distress Costs
Excessive Risk Taking
Under-investment
VU
0
D*
Value of Debt, D

Advanced Corporate Finance
Jörg Stahl

Optimal Debt Level

The optimal debt level

• R&D-Intensive Firms?
• Low-Growth, Mature Firms?

Advanced Corporate Finance
Jörg Stahl

Debt Levels in Practice

Debt levels in practice

• Although the tradeoff theory explains how firms should choose
  their capital structures to maximize value to current shareholders, it
  may not coincide with what firms actually do in practice

Advanced Corporate Finance
Jörg Stahl

Debt Levels in Practice: Management Entrenchment Theory

• A theory that suggests managers choose a capital structure to avoid
  the discipline of debt and maintain their own job security
• Managers seek to minimize leverage to prevent the job loss that
  would accompany financial distress, but are constrained from using
  too little debt (to keep shareholders happy)
• Asymmetric Information and relevance for Capital Structure?

Advanced Corporate Finance
Jörg Stahl

Asymmetric Information and Capital Structure

Asymmetric Information and relevance for Capital Structure?

• A situation in which parties have different information
• For example, when managers have superior information to
  investors regarding the firm's future cash flows

Advanced Corporate Finance
Jörg Stahl

Leverage as a Credible Signal

Credibility Principle

• The principle that claims in one's self-interest are credible only if
  they are supported by actions that would be too costly to take if the
  claims were untrue.
• "Actions speak louder than words."

Advanced Corporate Finance
Jörg Stahl

Leverage as a Credible Signal: Firm Project Communication

• Assume a firm has a large new profitable project, but cannot
  discuss the project due to competitive reasons
• How can the firm credibly communicate this information?

Advanced Corporate Finance
Jörg Stahl

Leverage as a Credible Signal: Signaling Theory of Debt

Signaling Theory of Debt

• The use of leverage as a way to signal information to investors
• Thus a firm can use leverage as a way to convince investors that it does have
  information that the firm will grow, even if it cannot provide verifiable details
  about the sources of growth

Advanced Corporate Finance
Jörg Stahl

Example: Debt Signals Strength

Problem

Suppose that Beltran currently uses all-equity financing, and that Beltran's market value in one
year's time will be either $100 million or $50 million depending on the success of the new
strategy. Currently, investors view the outcomes as equally likely, but Smith has information that
success is virtually certain. Will leverage of $25 million make Smith's claims credible? How about
leverage of $55 million?

Advanced Corporate Finance
Jörg Stahl

Issuing Equity and Asymmetric Information

• Firms may be reluctant to issue equity due to asymmetric
  information.
• Why?

Advanced Corporate Finance
Jörg Stahl

Issuing Equity and Adverse Selection

Adverse Selection?
Lemons Principle?

Advanced Corporate Finance
Jörg Stahl

Issuing Equity and Adverse Selection: Future Projects

• Firms that sell new equity have private information about the
  quality of the future projects
• However, due to the lemon principle, buyers are reluctant to believe
  management's assessment of the new projects and are only willing to buy the
  new equity at heavily discounted prices
• Therefore, managers who know their prospects are good (and whose
  securities will have a high value) will not sell new equity
• Only those managers who know their firms have poor prospects (and whose
  securities will have low value) are willing to sell new equity

Advanced Corporate Finance
Jörg Stahl

Issuing Equity and Adverse Selection: Lemons Problem

• The lemons problem creates a cost for firms that need to raise
  capital from investors to fund new investments
• If they try to issue equity, investors will discount the price they are
  willing to pay to reflect the possibility that managers have bad news

Advanced Corporate Finance
Jörg Stahl

Example: Adverse Selection in Equity Markets

Problem

Zycor stock is worth either $100 per share, $80 per share, or $60 per share. Investors believe each
case is equally likely, and the current share price is equal to the average value of $80.
Suppose the CEO of Zycor announces he will sell most of his holdings of the stock to diver-
sify. Diversifying is worth 10% of the share price-that is, the CEO would be willing to receive
10% less than the shares are worth to achieve the benefits of diversification. If investors believe
the CEO knows the true value, how will the share price change if he tries to sell? Will the CEO
sell at the new share price?

Advanced Corporate Finance
Jörg Stahl

Stock Returns Before and After an Equity Issue

60
Down
3%
Return Relative to Market (%)
>
50
40
Up
47%
30
20
10
0
-500
-400
-300
-200
-100
0
100
Days Relative to Equity Issue Announcement

Advanced Corporate Finance
Jörg Stahl

Implications for Equity Issuance

The lemons principle directly implies that:

• The stock price declines on the announcement of an equity issue
• The stock price tends to rise prior to the announcement of an equity
  issue
• Firms tend to issue equity when information asymmetries are
  minimized, such as immediately after earnings announcements

Advanced Corporate Finance
Jörg Stahl

Implications for Capital Structure

• What are the implications for capital structure?
• Who (firms with overpriced versus underpriced equity) prefers
  which type of financing?

Advanced Corporate Finance
Jörg Stahl

Implications for Capital Structure: Funding Preferences

• Managers who perceive the firm's equity is underpriced will have a
  preference to fund investment using retained earnings, or debt,
  rather than equity

Advanced Corporate Finance
Jörg Stahl

Implications for Capital Structure: Pecking Order Hypothesis

Pecking Order Hypothesis

• The idea that managers will prefer to fund investments by first
  using retained earnings, then debt and equity only as a last resort
• Does the hypothesis provide a clear prediction regarding capital
  structure?

Advanced Corporate Finance
Jörg Stahl

Aggregate Sources of Funding for Capital Expenditures, U.S. Corporations

Funding of Capital Expenditures
150%
-
Equity
-
Debt
-
Internal
125%
100%
75%
50%
25%
0%
-25%
-50%
-75%
1995
2000
2005
2010
Year
Source: Federal Reserve Flow of Funds.

Advanced Corporate Finance
Jörg Stahl

Exercise: Nesbat Industries Funding Costs

• Nesbat Industries needs to raise $25 million for a new investment
  project
• If the firm issues one year debt, it may have to pay an interest rate
  of 10%, although Nesbat's managers believe that 8% would be a fair
  rate given the level of risk
• However, if the firm issues equity, they believe the equity may be
  underpriced by 7.5%
• What is the cost to current shareholders of financing the project
  out of retained earnings, debt, and equity?

Advanced Corporate Finance
Jörg Stahl

Equity Mis-valuation

• Do practitioners care about equity mis-valuation?
• How frequent is mis-valuation?

Advanced Corporate Finance
Jörg Stahl

Company's Equity Mis-valued by Investors?

Never, 7%
Frequently,
21%
Rarely, 23%
Occassionally,
49%
Source: Servaes, H. and P. Tufano, 2006. CFO views on the importance and execution of the finance function. Deutsche Bank Working paper.

Advanced Corporate Finance
Jörg Stahl

Average Degree of Mis-valuation Over the Last 5 Years

20%
Undervaluation: 82%
Overvaluation: 18%
18%
16%
16%
14%
12%
12%
11%
10%
9%
9%
10%
8%
6%
6%
5%
4%
4%
4%
4%
3%
3%
2%
1% 1%
1%
0%
0%
-20%
-17.5%
-15%
-12.5%
-10%
-7.5%
-5%
-2.5%
0%
2.5%
5%
7.5%
10%
12.5%
15%
17.5%
20%
Average Misvaluation
Source: Servaes, H. and P. Tufano, 2006. CFO views on the importance and execution of the finance function. Deutsche Bank Working paper.

Advanced Corporate Finance
Jörg Stahl

Greatest Degree of Mis-valuation in the Last 5 Years

4%What is the greatest degree of mis-valuation in the last 5 years?
Greatest Equity Undervaluation
Greatest Equity Overvaluation
50%
N = 133
47%
50%
N = 71
40%
40%
28%
30%
30%
25%
20%
20%
13%
11%
10%
10%
10%
7%
6%
5%
4%
3%
2%
0%
0%
0%
2.5%
5%
7.5%
10%
12.5%
15%
17.5%
20%
0%
2.5%
5%
7.5%
10%
12.5%
15%
17.5%
20%
Greatest Degree of Undervaluation
Greatest Degree of Overvaluation
Source: Servaes, H. and P. Tufano, 2006. CFO views on the importance and execution of the finance function. Deutsche Bank Working paper.

Advanced Corporate Finance
Jörg Stahl

Factors Affecting Firm's Debt Policy

10%
8%
10%
4%
4%
3%What other factors affect your firm's debt policy?
(% important or very important)
Issue debt when recent profits (internal funds) are
not sufficient to fund activities
Issue debt when interest rates are particularly low
Use debt when equity is undervalued by the market
Changes in the price of common stock
Delay issuing debt because of transaction costs and
fees
0%
10% 20% 30% 40% 50%
Source: Graham, J.R. and C. Harvey, 2001. The theory and practice of corporate finance: Evidence from the field, Journal of Financial
Economics 60, 187-243.
.

Advanced Corporate Finance
Jörg Stahl

Capital Structure: The Bottom Line

The optimal capital structure depends on market imperfections, such
as taxes, financial distress costs, agency costs, and asymmetric
information

Advanced Corporate Finance
Jörg Stahl