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Lecture 7: Asymmetric information
and signalling with capital structure choice

Anton Miglo
Fall 2008

ECON 4560, Anton Miglo
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Topics

 Insiders and outsiders
 Information manipulations and credible
signalling
 Pecking-order theory
 Signalling by “risk-bearing”

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Insiders and Outsiders

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Asymmetric Information Problem

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Example
Two 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 Model
Two 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”
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• 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      Variance
profit
Type 1     100           100

Type 2     200           100

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Patterns of Corporate Financing

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Debt Ratios for some Industries
Industry                    Debt to Value Ratio

Internet                             .0218
Educational Services                 .0224
Drugs&Cosmetics                     .0907
Instruments                        .1119
Metal Mining                      .1347
Electronics                       .1579
Machinery                          .1957
Food                               .2056
Construction                      .2384
Petroleum Refining                .2436
Chemicals                          .2544
Apparel                            .2603
Motor Vehicles Parts                .2714
Paper                               .2895
Textile Mill Products              .3257
Retail Dept Stores                  .3433
Trucking*                         .3730
Steel                              .3819
Telephone*                         .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     Security          Two-Day
Issued      Retired      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%

ECON 4560, Anton Miglo

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