Financial Innovation Information Asymmetry. P.V. Viswanath Summer 2007. Information Asymmetry and Adverse Selection. Information Asymmetry between the two parties to a trade sometimes prevents the occurrence of that trade, even if it is potentially beneficial to both parties.
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Payoffs to the two projects
Proj. 1 is better for the entire firm
Proj. 1 is better for bondholders
Proj. 2 is better for equityholders
The reason for the bad choice is that stockholders do not share in the upside but share in the downside.
Consider a firm with $4000 of principal and interest payments due at the end of the year (assume $3500 lent at 14.29% stated). If there is a recession, it will be pulled into bankruptcy because its cash flows will be only $2400. Else, it will have cash flows of $5000.
The firm could avoid bankruptcy in a recession by raising new equity to invest in a new project (soon after beginning). The project costs $1000 and brings in $1400 in either state and has an NPV > 0.
Recession and Boom states are equally likely.
Will it do the right thing and raise new equity funds?
The new project will not be undertaken. Stockholders have on av. $500 without the project, and $200 with the project [(2400)/2 – 1000].
Equityholders won’t want to borrow money on the original terms either; it still won’t be worthwhile.
Two stage financing structured as a loan commitment. Fee = $150 plus 110% of draw-down. Tot Ret for bondholders (w/proj) = 0.5(5100/4500)+0.5(3800/3500)=10.95%