7- 1 ECON 4560, Anton Miglo Lecture 7: Asymmetric information and signalling with capital structure choice Anton Miglo Fall 2008

7- 2 ECON 4560, Anton Miglo Topics  Insiders and outsiders  Information manipulations and credible signalling  Pecking-order theory  Signalling by “risk-bearing”  Additional readings: GT ch. 19

7- 3 ECON 4560, Anton Miglo Insiders and Outsiders

7- 4 ECON 4560, Anton Miglo Asymmetric Information Problem

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

7- 6 ECON 4560, Anton Miglo Adverse Selection: Market for Lemons

7- 7 ECON 4560, Anton Miglo 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.

7- 8 ECON 4560, Anton Miglo 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.

7- 9 ECON 4560, Anton Miglo Pecking-order Theory

7- 10 ECON 4560, Anton Miglo Signalling by “risk-bearing”

7- 11 ECON 4560, Anton Miglo 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) Expected profit Variance Type 1100 Type

7- 12 ECON 4560, Anton Miglo Patterns of Corporate Financing

7- 13 ECON 4560, Anton Miglo 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

7- 14 ECON 4560, Anton Miglo Implications a See Leland and Pyle (1997) and Myers and Majluf (1984). b See Miller and Rock (1985). c See Ross (1977)

7- 15 ECON 4560, Anton Miglo Stock Market Response to Pure Capital Structure Changes Security Issued Security Retired Two-Day Announcement Period Return Leverage Increased Stock RepurchaseDebtCommon21.9% Exchange offerDebtCommon14.0% Exchange offerPreferredCommon8.3% Leverage reduced Exchange offerCommonDebt-9.9% Security SalesCommonDebt-4.2% Conversion-forcing callCommonConvertible-0.4% Conversion-forcing callCommonPreferred-2.1%