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Lecture 7: Asymmetric information and signalling with capital structure choice

Lecture 7: Asymmetric information and signalling with capital structure choice. Anton Miglo Fall 2008. Topics. Insiders and outsiders Information manipulations and credible signalling Pecking-order theory Signalling by “risk-bearing” Additional readings: GT ch. 19. Insiders and Outsiders.

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Lecture 7: Asymmetric information and signalling with capital structure choice

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  1. Lecture 7: Asymmetric information and signalling with capital structure choice Anton Miglo Fall 2008

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

  3. Insiders and Outsiders

  4. Asymmetric Information Problem

  5. Information Disclosing and Information Manipulation

  6. Adverse Selection: Market for Lemons

  7. 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.

  8. 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.

  9. Pecking-order Theory

  10. Signalling by “risk-bearing”

  11. Signalling by “risk-bearing” • 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)

  12. Patterns of Corporate Financing

  13. 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

  14. Implications a See Leland and Pyle (1997) and Myers and Majluf (1984). bSee Miller and Rock (1985). cSee Ross (1977)

  15. Stock Market Response to Pure Capital Structure Changes

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