Advanced Corporate Finance Lecture 8

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Lecture 7 Asymmetric information
Anton Miglo Fall 2005
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Insiders and Outsiders

• The terms insider and outsider refer to those
  people who are privy to
• relevant firm information and those who are
  not, respectively
• This asymmetry of information comes up in a
  number of situations
• and a large body of research has been carried
  out on the topic
• Those people with inside information usually have
  a strategic
• advantage against those without
• As we will see throughout this lecture and the
  next, having inside
• information will sometimes work in the favor of
  insiders and
• sometimes be a disadvantage
• Information asymmetries are characterized by one
  person or organization having more information
  than another person or organization. We will
  refer to the person having more information as
  the insider and the person with less
  information as the outsider.

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Asymmetric Information Problem

• Throughout this course we have discussed ways
  that a firm can maximize its value, and the
  wealth of shareholders, by investing in certain
  projects and controlling the amount of debt on
  the balance sheet
• Thus in a world with perfect information,
  maximizing the value of a firm would be easy.
  The only problem is, we do not live in a world
  with perfect information
• The fact is, information asymmetries exist in
  almost every facet of corporate
• finance and they significantly complicate the
  methods used by owners, and their
• overall ability to maximize firm value
• Examples of corporate relationships that harbor
  information asymmetries are
• managers and owners, owners and creditors, old
  shareholders and new
• shareholders, etc..

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The Conflicting Goals of Management

• Outsiders must rely on financial reports and the
  actions taken by a firm to generate an informed
  opinion on the value and prospects of a firm.
• Management can use this to their advantage,
  adopting
• strategies (for instance, earnings
  manipulations) that misleading potential
  investors and creditors into thinking the firm is
  more valuable than it is
• On occasion these strategies are detrimental to
  the intrinsic
• value of the firm
• Therefore management faces a dilemma regarding
  weather they should increase the intrinsic value,
  or the perceived value of a firm

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Reasons for Information Manipulation

• There are a number of reasons management may want
  the short term price of a firms securities to be
  higher or lower than the value they are trading
  at, here are a few
• Some investors may own equity as a long-term
  investment while others may want to sell their
  securities in the near future. Those owners who
  wish to sell their securities will put pressure
  on managers to fluff up the market price even at
  the cost of the firms long-term intrinsic value
• Regulated equity exchanges such as the TSX or
  NYSE have minimum share price requirements, if a
  firms stock trades near or below this price,
  management may need to beef up the securities
  price. Though the same result can be
  accomplished with a reverse stock split
• Managers may be concerned about a hostile
  takeover of their firm by another company. If
  the manager can increase the short term price of
  equity the purchasing firm may find that it is no
  longer in their interest to pursue the acquisition

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• 4. The ability to attract customers and other
  outside stakeholders may be related to outsiders
  perceptions of the firms value.
• 5. Firms may want to buy back some of their
  outstanding dept, by issuing equity and causing a
  devaluation of the firms assets, the debt will
  become cheaper.

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Methods Used to Manipulate the Perception of
Outsiders
1. Short sighted investment by investing in
projects that payoff sooner, even though they
have lower NPVs than project that payoff later,
a firm can boost its short run profits.
Outsiders may believe that these extraordinary
profits will continue into the future and
subsequently bid up the short term price of
equity. 2. Earnings manipulations anyone who
has taken a corporate accounting course knows
that accountants can be very creative when it
comes to income statements and balance sheets.
Certain items, such as how depreciation is
calculated or the percentage of accounts
receivables written off as uncollectable, is to a
large part determined by the management. This
gives management the ability to inflate reported
profit for a short period of time. This does not
change the value of the firm but the perceptions
of outsiders.
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Information Disclosing and Signals

• Insiders may not be able to disclose their
  information to the firms claimholders because
• The information may be valuable for the
  competitors
• Risk of being sued by investors if they make
  forecasts that later turn out to be inaccurate
• Managers may be reluctant to disclose bad
  information
• The information may be difficult to quantify
• As a result, the investors will not believe too
  much to the direct information and will try to
  incorporate indirect evidence in their valuation
• It can be done through the analysis of
  information-revealing actions (signals). These
  can include investment decisions, financing
  decisions, dividend decisions etc.

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Adverse Selection

• The basic idea of adverse selection is that bad
  quality items drive good quality
• items out of the market
• The idea of adverse selection was exemplified in
  a famous 1970 paper by George Akerloff, A 2001
  Nobel Prize Laureate.
• The paper was called The market for
  Lemmons..
• Idea (class)

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Adverse Selection As It Applies to Corporate
Finance

• Financing Under Asymmetric Information

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Issuing Equity

• Managers and owners have private information
  about the true value of a firm,
• market participants do not have this
  information
• If a firm issues equity to fund a new project, it
  is inviting outside investors to share not only
  in the project but also in the assets of the firm
• Investors will infer from this that the existing
  assets and future cash flows of the
• firm are not that valuable
• So, not knowing for sure the true value of the
  firm, potential investors will not be willing to
  pay very much for this new equity
• Afterwards, if the firm turns out to be good,
  then the equity was underpriced

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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.

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Equity Financing Under Symmetric Information

• Outside investors know the value of existing
  assets (100).
• When they buy equity, if they get a fraction a of
  the firm, their wealth in period 2 is a190 and of
  course in a competitive market (remember no
  discounting) this will equal the cost 70. Thus

• Thus the new shareholders will ask for 7,000,000
  additional shares and the share price will be
  70/7 10 per share

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• The inside equity (the entrepreneur) is worth the
  fraction (1-a) of the firm

W (1 - a)190 120

• Since 120 100 he clearly will issue the new
  equity
• The owner extracts the entire rent from this new
  project.

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Equity Financing Under Asymmetric Information

• Assume the initial assets can take two values,
  40 and 160. The true value of this is unknown
  in the beginning but becomes soon known by the
  entrepreneur (inside equity).
• Outside investors have a prior probability 50
  that the value equals to 160.
• This defines the expected intrinsic value as EX
  p 160 (1-p) 40 100
• If the project is not undertaken, the
  entrepreneur's wealth WNI is 40 or 160
• depending on the firm's type

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• Suppose now that equity is issued under the
  expected value of the firm
• Competitive capital market implies 70 a (0.5
  130 0.5 250) a (190) where investors now
  break even only in expectation
•  
• The necessary equity fraction required by
  outsiders is then

• The wealth of the entrepreneur when he invests is
  now given by
• (for high-value type)

• For low-value type it is

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The Owners Decision

• So, a low type firm will invest because 82 40
  while the high value type will not
• because 157
• This is a clear case of adverse selection, bad
  firms chase good firms away from
• issuing equity
• When observing new issue of shares, investors
  rationally realize that the firm that
• issues shares is low-value type
•  
• Competitive capital market implies 70 a (4090)
•  
• The necessary equity fraction required by
  outsiders is

• The wealth of the entrepreneur when he invests is
  now given by
• (for low-value type)

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Share Price

• In the beginning the share price is 100 / 12
  8.33
• The price of shares sold during the issue is the
  number of shares is 14 million.
• Thus the price is 70 / 13 5.38

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Some Results

• The price of newly issued shares is typically low
• Firms prefer financing by debt to financing by
  equity (pecking-order)
• The result can be generalized by allowing more
  than two types, internal funds and assets in
  place.

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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 RB.
• The cash flow of the firm in period 2 is XR 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 RB 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.

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Equity Financing Under Symmetric Information

• Suppose that outside investors know X.
• When they buy equity, if they get a fraction a of
  the firm, their wealth in period 2
• is aXR and of course in a competitive market
  (remember no discounting) this
• will equal the cost B. Thus

• The inside equity (the entrepreneur) is worth the
  fraction (1-a) of the firm
• W (1-a)XR X R
  B
• Since R B he clearly will issue the new equity
  because W X
• The initial owner extracts the entire rent from
  this new project.

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Equity Financing Under Asymmetric Information

• Now lets look at asymmetric information
• Assume X can take two values, L and H. The true
  value of X is only known by the entrepreneur
  (inside equity).
• Outside investors have a prior probability that
  the firm is type H equal to p.
• This defines the expected intrinsic value as
  EXpH(1-p)L
• If the project is not undertaken, the inside
  equity retains its value X H, or L, and the
  entrepreneur's wealth is
•   WNI X

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• Suppose now that equity is issued under any value
  of X.
• Competitive capital market implies B a(EXR)
  where investors now break even only in
  expectation
• The necessary equity fraction required by
  outsiders is then

• Note that ae is decreasing in p the better the
  prior that the firm is good, the less
• outside investors require
• The wealth of the entrepreneur when he invests is
  now given by
• WI (1-ae)XR
• Notice that it is X, and not EX in this
  expression.

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The Owners Decision

• His optimal choice depends on

• where
• Now, if X L he will surely invest as R B
  anyway. In addition, the U factor will be less
  than one.
• So, a low type firm is overpriced in the sense
  that its cost of capital is too low.
• Investors think the firm is better than it really
  is, and so require a smaller share in the firm
  (thus lower returns) than they should.
• Now, if XH he may not invest even though RB .
  This is because the U factor is now bigger than
  1.

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Results

• A high type firm is underpriced in the sense that
  its cost of capital is too high
• Investors think the firm is worse than it really
  is, and so require a bigger share in
• the firm (thus higher returns) than they need
  to
•  
• If debt is risk-free there is no problem. A
  positive NPV project will be undertaken.
•  
• One can show that risky debt is better than
  equity. (more difficult)
•  
• So a pecking order emerges retained earnings,
  debt, and then equity
•  
• Debt is better than equity if there is a faster
  drop in the share price when new equity is
  issued, than a rise in bankruptcy probability
  when new debt is issued.

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Patterns of Corporate Financing
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Debt Ratios for some Industries

• Industry
  Number of Firms Debt to Value
  Ratio1
• in
  Industry Sample Mean (Standard
  Deviation)
• DrugsCosmetics 31
  .0907
  (.095)
• Instruments
  27
  .1119 (.086)
• Metal Mining
  23
  .1347 (.099)
• Electronics
  77
  .1579 (.121)
• Machinery
  80
  .1957 (.114)
• Food
  50
  .2056 (.128
• Construction
  12
  .2384 (.151)
• Petroleum Refining 31
  .2436
  (.121)
• Chemicals
  47
  .2544 (.135)
• Apparel
  18
  .2603 (.123)
• Motor Vehicles Parts 52
  .2714
  (.138)
• Paper
  24
  .2895 (.114)
• Textile Mill Products 21
  .3257
  (.133)
• Retail Dept Stores 20
  .3433
  (.150)
• Trucking
  10
  .3730 (.209)
• Steel
  45
  .3819 (.195)

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Implications
a See Leland and Pyle (1997) and Myers and Majluf
(1984). bSee Miller and Rock (1985). cSee Ross
(1977)
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Stock Market Response to Pure Capital Structure
Changes
Note Exhibits 18.4 and 18.5 are slightly altered
versions of tables reported in Smith
(1986).SourcesaMasulis (1980).bMasulis
(1983). These returns include announcement days
of both the original offer and, for about 40
percent of the sample, a second announcement of
specific terms of the exchange.cMcConnell and
Schlarbaum (1981).dDietrich (1984).eMikkelson
(1981).fEckbo (1986) and Mikkelson and Partch
(1986).
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Stock Price Reactions to Security Sales
SourcesaThese figures are based on calculations
by Eckbo and Masulis (1995), see also Asquith and
Mullins (1986). Masulis and Korwar (1986),
Mikkelson and Partch (1986), Schipper and Smith
(1986), and Pettway and Radcliff (1985).bLinn
and Pinegar (1988) and Mikkelson and Partch
(1986).cLinn and Pinegar (1988).dDann and
Mikkelson (1984). Eckbo (1986), and Mikkelson and
Partch (1986).oInterpreted by the authors as
insignificantly different from zero.