Outside Financing Under Asymmetric Information Plan for this part: Lemons problem in financial markets Market breakdown Market breakdown Overinvestment (bad projects are financed) Overinvestment (bad projects are financed) Debt as a way to minimize the effects of information asymmetry. Pecking order theory. Signaling By debt By debt By ownership structure By ownership structure By collateral By collateral …

Why does this happen? Source: Deborah Lucas and Robert McDonald, Equity Issues and Stock Price Dynamics, Journal of Finance 45 (1990): 1019–1043.

Asymmetric information and Capital Structure In contrast to the agency problems theories, here the way of financing does not affect managerial actions. However, the way of financing affects what investors think about your firm and how much they will underprice/overprice the claims you sell Hence, MM breaks down and you are not indifferent between debt financing and equity financing

Adverse Selection Problem Assume there are two equally likely states of nature (1 – good news, 2 – bad news) The firm has liquid assets L i and tangible assets in place A i After the news has arrived the firm considers: (1) do nothing or (2) issue 100 of new equity to new shareholders Do Nothing Issue Equity GoodBadGoodBad LiLiLiLi AiAiAiAi V i (firm value)

Can it be that the firm issues equity in both states? If the market thinks the firm issues 100 of equity in any state, it values the firm after investment as V = 0.5* *230 = 290 The existing shareholders in the good state than get: ((V-E)/V)*V 1 = (190/290)*350 = < 250 Hence, they will choose not to issue equity in the good state Hence, if a firm issues equity it must be in the bad state. Then the market knows V = 230. The existing shareholders than get ((V-E)/V)*V 2 = (130/230)*230 = 130. Hence, in the bad state the firm is indifferent between issuing and doing nothing We have lemons problem. In the good state the firm is underpriced and does not want to issue equity. Only in a bad state a firm may want to issue and the market forms believes accordingly.

Lets introduce a positive NPV project Do Nothing Issue Equity GoodBadGoodBad LiLiLiLi AiAiAiAi NPV of new project, b i V i (firm value)

If the market thinks the firm issues 100 of equity in any state, it values the firm after investment as V = 0.5* *240 = 305 The existing shareholders in the good state than get: ((V-E)/V)*V 1 = (205/305)*370 = < 250 Hence, they will still not choose not to issue equity in the good state Hence, if a firm issues equity it must be in the bad state. Then the market knows V = 240. The existing shareholders than get ((V-E)/V)*V 2 = (140/240)*240 = 140 > 130. Now in the bad state the firm strictly prefers to issue! Can it be now that the firm issues equity in both states?

The above result is consistent with the empirical observation: the stock price declines on the announcement of an equity issue (for US on average by 3%) Two other results that follow from the theory and are observed in practice: The stock price tends to rise prior to the announcement of an equity issue (managers wait until good news become known to the market, but does not have an incentive to wait when the news is bad) The stock price tends to rise prior to the announcement of an equity issue (managers wait until good news become known to the market, but does not have an incentive to wait when the news is bad) Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements

Depending on the model other types of equilibria can exist Notice: if we make NPV of the project in the good state a bit bigger, the firm will issue equity in the good state. There are two types of inefficiency that can created by asymmetric info Positive NPV projects fail to be financed (like in our model) – market breakdown Positive NPV projects fail to be financed (like in our model) – market breakdown Negative NPV projects may happen to be financed! (It happens when in the good state the project has NPV > 0, in the bad state NPV 0 and there is a pooling equilibrium) – overinvestment Negative NPV projects may happen to be financed! (It happens when in the good state the project has NPV > 0, in the bad state NPV 0 and there is a pooling equilibrium) – overinvestment

Implication for capital structure Pecking order theory: among the methods of financing firms that feel underpriced should start from the one which is least sensitive to information: First – retained earnings (liquid assets L i ) First – retained earnings (liquid assets L i ) Second – debt Second – debt Third – equity Third – equity Reason: insensitivity to information reduces the discount good firms incur when they sell their securities

Aggregate Sources of Funding for Capital Expenditures, U.S. Corporations In aggregate, firms tend to repurchase equity and issue debt. But more than 70% of capital expenditures are funded from retained earnings. Source: Federal Reserve Flow of Funds.