Asymmetric Information & Signaling (II) PDF

Introduction Example Formal model Debt financing Pecking order theory Asymmetric information & Signaling (II) Alexander Schandlbauer 1 / 26  Introducti...

Introduction Example Formal model Debt financing Pecking order theory Asymmetric information & Signaling (II) Alexander Schandlbauer 1 / 26  Introduction Example Formal model Debt financing Pecking order theory Outline 1 Introduction 2 Example 3 Formal model 4 Debt financing 5 Pecking order theory 2 / 26  Introduction Example Formal model Debt financing Pecking order theory Motivation the general setting Consider a firm with assets-in-place an a valuable real investment opportunity It has to issue common shares to raise part (or all) of the cash needed to undertake the investment project The real option expires if the firm does not raise the required funds in time Existing finance theory (remember from 1984!) advises the firm to evaluate the project as if it had plenty of cash on hand ▶ The decision rule: take every positive NPV project regardless of whether internal or external funds are used to pay for it What happens if the firm’s managers know more abut the value of assets-in-place and the investment opportunity than outside investors? 4 / 26  Introduction Example Formal model Debt financing Pecking order theory Myers and Majluf (1984) Corporate Financing and Investment Decisions when Firms have Information that Investors do not have Main idea of the paper: A firm has access to a real investment opportunity The manager of the firm has superior information about the project and the asset in place How should the manager finance the project? Two possibilities: ▶ Cash (internal financing) ▶ Equity or debt (external financing) Main result: If the manager maximizes existing passive shareholders’ wealth, the manager prefer internal financing ≻ debt ≻ equity ⇝ Pecking order 5 / 26  Introduction Example Model Formal model Information structure Debt financing Numerical example Pecking order theory Assumptions and settings Assumptions: Perfect capital market ▶ i.e. no taxes, transaction costs or other capital market imperfections The manager has information that investors do not have ▶ both managers and investors realize this For now: no risky debt The riskfree interest rate rf = 0 Notation: S... denotes the financial slack (known to the market), i.e. ▶ S = cash + marketable securities (+ risk free debt) I... denotes the required investment ▶ the investment must take place at time t = 0 ▶ if the firm does not launch the project opportunity promptly, the opportunity will evaporate If S < I, the firm needs E = I − S at t = 0 to undertake a project ▶ provided by new equity/shareholders 8 / 26  Introduction Example Model Formal model Information structure Debt financing Numerical example Pecking order theory A three-date model Values at date t = −1: Value of asset-in-place: Ā = E[Ã] ▶ distr. of à represents the asset’s possible values at t = 0 NPV(project) = B̄ = E[B̃] ▶ distr. of B̃ represents the asset’s possible NPVs at t = 0 Managements updated estimates at t = 0: Realization of à = a and B̃ = b Information structure: time t = −1 t =0 t =1 Manager S, distr. (Ã, B̃) a, b, S a, b, remaining S S, distr. (Ã, B̃), Market S, distr. (Ã, B̃) a, b, remaining S E ∈ {0, I − S} 10 / 26  Introduction Example Model Formal model Information structure Debt financing Numerical example Pecking order theory Further assumptions Assume: a ≧ 0, b ≧ 0 ⇝ manager is not empire building Management acts (beginning at t = 0) on behalf of “old shareholders”, i.e. max V0old = V (a, b, E) (“intrinsic value”) Note: due to asymmetric information, usually: intrinsic value ̸= market value  ′ P... issue stock Market value of old shares at t = 0 = P... don’t issue Passive old shareholders ⇝ not act upon investment ▶ Hence if E > 0 (issue equity) the issue goes to other (new) s.h. 11 / 26  Introduction Example Model Formal model Information structure Debt financing Numerical example Pecking order theory Why pass up NPV > 0 projects? Assume: Three dates and two equally probable states of nature S = 0, I = 100 → E = 100 is needed to undertake investment Consider the strategies 1 Issue equity and invest in both states 2 Don’t issue and never invest Payoffs to old shareholders [Blackboard] E = 100 E =0 old Vst.=1 144.42 < 150.00 old Vst.=2 85.58 > 50.00 Dominating strategy: Invest only in state 2 E = 100 E =0 old Vst.=1 − 150 old Vst.=2 60 − 13 / 26  Introduction Example Model Formal model Information structure Debt financing Numerical example Pecking order theory The cost of asymmetric information Note: In state 1 we have that NPV(project) = 20> 0, but the project is not initiated Hence there is a cost of asymmetric information: old 1 1 Vfull info = (150 + 20) + (50 + 10) = 115 2 2 old 1 1 Vasym info = · 150 + · 60 = 105 2 2 Ex ante loss = 115 − 105 = 10 Slack (S) allows the firm to avoid the consequences of managers’ inside information 14 / 26  Introduction Example Model Formal model Information structure Debt financing Numerical example Pecking order theory Discussion The conventional rationale for holding financial slack is that the firm doesn’t want to have to issue equity on short notice to undertake a valuable investment opportunity ▶ don’t want to be forced to issue equity when the firm is undervalued by the market Using the same logic: The firm must also sometimes be overvalued ⇝ why can’t firms take advantage of the market by issuing only when the firm is overpriced? Slack (S) allows the firm to avoid the consequences of managers’ inside information ▶ without slack the firm is sometimes unwilling to issue equity and therefore passes up a good investment ▶ slack does not allow the firm to take advantage of investors by issuing only when equity is overvalued ∗ if investors know the firm doesn’t have to issue to invest, then an attempt to issue sends a strong pessimistic signal 15 / 26  Introduction Example Formal model Debt financing Pecking order theory Condition for the firm to issue stock Assume: E = I − S > 0, S ≥ 0 The old shareholders are better off if the firm issues only when value if not issue ≦ value if issue P′ ⇔ V old = S + a ≦ V old = (S + a + E + b) P′ + E E ⇔ b ≧ −E + ′ (S + a) (1) P If “=” in (1), then old shareholders are indifferent Illustration in a (a, b)-diagram ▶ M ′ -region: issue and invest ▶ M-region: don’t invest 17 / 26  Introduction Example Formal model Debt financing Pecking order theory Trade-off for equity issuance Issue equity if NPV(project), b, is sufficiently high compared to the payoff of assets in place, a Trade off for the old shareholders: ▶ give up asset payoff ▶ get some project payoff Note: ▶ low a: give up little ▶ high b: get a lot Note: M ′ and M depend on P ′. But P ′ depends on the joint density of (Ã, B̃) and the regions M ′ and M P ′ = S + Ā(M ′ ) + B̄(M ′ ) (2) where Ā(M ′ ) = E[Ã|E = I − S] and B̄(M ′ ) = E[B̃|E = I − S] ▶ the lower a the more attractive is the P ′ 18 / 26  Introduction Example Formal model Debt financing Pecking order theory Debt financing If the firm can issue default-risk-free debts: the problem disappears firm always undertake NPV > 0 projects If the firm only can issue risky debt: Investment problem alleviated, but not gone... Assumption: Suppose the financing policy (debt or equity) is decided upon at date t = −1 ⇝ the policy is strictly obeyed 20 / 26  Introduction Example Formal model Debt financing Pecking order theory Issue equity Equity: Issue E = I − S at t = 0 If E1 is market value of new shares at t = 1, then V old = S + a + b − (E1 − E) = S + a + b − ∆E ∆E is capital gain/loss to new shareholders at t = 1 Old shareholders want to issue and invest iff S + a ≦ S + a + b − (E1 − E) that is ∆E ≦ b (3) Interpretation 21 / 26  Introduction Example Formal model Debt financing Pecking order theory Issue debt Debt: Issue D = I − S at date t = 0 If D1 is the market value at t = 1 V old = S + a + b − (D1 − D) = S + a + b − ∆D ∆D is capital gain to debt holders at t = 1 The firm issue debt and invest iff ∆D ≦ b Note: if debt is default-risk-free, then ∆D = 0 Same effect as with more slack Note: if debt is risky, then ∆D can be positive or negative 22 / 26  Introduction Example Formal model Debt financing Pecking order theory Comparison of debt and equity financing Assume: 1 sgn(∆E) = sgn(∆D) 2 |∆E| > |∆D| Since b ≥ 0, the firm will always invest as long as ∆E, ∆D ≤ 0 What if ∆E, ∆D > 0? By assumption ∆E > ∆D Hence ∃ b > 0 : ∆D ≤ b < ∆E As a result, more NPV > 0 projects are undertaken with debt financing, i.e. less underinvestment Debt financing The ex ante value of the firm is higher with debt financing than with equity financing 23 / 26  Introduction Example Formal model Debt financing Pecking order theory Pecking order theory Assumption: the manager decides on financing at t = 0 (a and b is known to him) Hence no preannouncement at t = −1 The manager only issue if equity : b − ∆E ≧ 0 debt : b − ∆D ≧ 0 If the manager issues equity, then he signals that b − ∆E > b − ∆D ⇒ ∆E < ∆D 25 / 26  Introduction Example Formal model Debt financing Pecking order theory Pecking order theory continued Since E is more responsive to the revelation of information: |∆E| > |∆D| Therefore: firms will only prefer equity to debt if ∆E < 0 ▶ sure capital loss for the new equity holders There do not exits an equilibrium price PE′ where ▶ new equity is preferred over debt ▶ investors are willing to buy equity Hence this model: firms never issue new equity Pecking Order Theory Firms prefer internal financing If external financing ▶ bonds are preferred to stock 26 / 26