Advanced Corporate Finance Lecture 8

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					7- 1




                Lecture 7: Asymmetric information
          and signalling with capital structure choice

  Anton Miglo
         Fall 2008




ECON 4560, Anton Miglo
7- 2

                         Topics

        Insiders and outsiders
        Information manipulations and credible
         signalling
        Pecking-order theory
        Signalling by “risk-bearing”
        Additional readings: GT ch. 19



ECON 4560, Anton Miglo
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                     Insiders and Outsiders




ECON 4560, Anton Miglo
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              Asymmetric Information Problem




ECON 4560, Anton Miglo
7- 5     Information Disclosing and Information Manipulation




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          Adverse Selection: Market for Lemons




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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




ECON 4560, Anton Miglo
              Signalling by “risk-bearing”
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ECON 4560, Anton Miglo
              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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