Asymmetric information and Capital
Structure
In contrast to the agency costs problem,
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


Adverse selection problem
Signaling
Adverse Selection Problem
Assume there are two equally likely states of nature (1 –
good news, 2 – bad news)
The firm has liquid assets Li and tangible assets in place
Ai
After the news has arrived the firm cosniders: (1) do
nothing or (2) issue 100 of new equity to new
shareholders
Do Nothing
Issue Equity
Good
Bad
Good
Bad
Li
50
50
150
150
Ai
200
80
200
80
Vi (firm value)
250
130
350
230
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*350 + 0.5*230 = 290
The existing shareholders in the good state than get:
((V-E)/V)*V1 = (190/290)*350 = 229.31 < 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)*V2 = (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.
Let’s introduce a positive NPV project
Do Nothing
Issue Equity
Good
Bad
Good
Bad
Li
50
50
150
150
Ai
200
80
300
180
0
0
20
10
250
130
370
240
NPV of new
project, bi
Vi (firm value)
Can it be now 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*370 + 0.5*240 = 305
The existing shareholders in the good state than get:
((V-E)/V)*V1 = (205/305)*370 = 248.7 < 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)*V2 = (140/240)*240 = 140 > 130.
Now in the bad state the firm strictly prefers to issue!
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)
Firms tend to issue equity when information
asymmetries are minimized, such as immediately
after earnings announcements
Source: Deborah Lucas and Robert McDonald, “Equity Issues and Stock Price
Dynamics,” Journal of Finance 45 (1990): 1019–1043.
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)
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, but on average NPV >
0 and there is a pooling equilibrium)
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 Li)
Second – debt
Third – equity
Information insensitivity reduces the discount the
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.
Capital Structure. Bottom line
No single theory of capital structure

Too many factors are in play
Firms differ a lot in how they choose cap
structure but there are some systematic
patterns e.g. across industries or ages
In each case one should understand what
factors are most important
Capital budgeting and valuation
with leverage
Three methods:



WACC
Adjusted Present Value (APV)
Flow-to-Equity (FTE)
For this lecture we will assume that


Risk of the project to evaluate = risk of the firm
Debt/Equity remains constant
WACC Method
Note: here and below by D we will mean net
debt = debt – cash. I.e. we will value the project
net of its cash assets (that earn market interest
rate)
Example
Avco is considering introducing new product







Will become obsolete in 4 years
Annual sales: $60 mln per year
Manufacturing costs and operating expenses: $25
mln per year and $9 mln per year
Upfront R&D and marketing expenses: $6.67 mln
Upfront equipment expenses: $24 mln
No NWC requirements
Tax rate = 40%
Expected Free Cash Flow from Avco’s
RFX Project (Spreadsheet)
Market risk of the project is expected to be similar to that
of the company’s other lines business.
Debt/equity ratio is supposed to stay the same
Avco’s Current Market Value Balance Sheet ($ million)
and Cost of Capital Without the RFX Project:
rwacc
E
D

rE 
rD (1   c )  6.8%
ED
ED
(Remember D = net debt = 300)
18
18
18
18
V 



 $61.25 mln
2
3
4
1.068 1.068 1.068 1.068
L
0
NPV = 61.25 – 28 = $33.25 mln
Notes:
• we use the same WACC for all periods
because we assume that D/E remains
constant
• we use the WACC of the firms because we
assume the project does not change D/E
Implementing a constant DebtEquity ratio
Currently Avco has D/E = 1
By undertaking the new project Avco adds new
assets to the firm with initial market value VL0 =
$61.25 mln.
Therefore, to maintain D/E constant Avco must
add 0.5*61.25 = $30.625 mln in new debt (net
debt)
For this it can e.g. spend its 20 mln in cash and
borrow 10.625 mln
Since only 28 mln is needed to fund the projects,
the rest 30.625 – 28 = 2.625 will be paid to
shareholders as dividend (or share repurchase)
Avco’s Current Market Value Balance
Sheet ($ million) with the RFX Project
OK, in this way we can make sure the
project doest not change D/E initially. But
what happens with time?
We can ensure constant D/E further by properly
adjusting debt each period
We call the necessary for this amount of debt “debt
capacity”, denote Dt
Here VLt – the project’s levered continuation value, i.e.
Continuation Value and Debt Capacity of
the RFX Project over Time (Spreadsheet)
Adjusted Present Value Method
We have to compute VU and PV(Interest
Tax Shield). Let’s ignore other stuff.
To compute VU we need to compute rU
Why is rU like this? From MM II with taxes
it seems it should be:
E
D(1   c )
rU 
rE 
rD
E  D(1   c )
E  D(1   c )
But MM II was derived (see lecture 8)
under the assumption that debt is constant
in perpetuity, NOT debt-equity ratio!
What does it change?
Similarly to lecture 8:




VL ≡ E + D = VU + TS
Thus, DrD + ErE = VUrU + TSrTS
But when D/E is kept constant rTS = rU
(interest tax shield becomes risky and has a
similar risk to the project’s cash flows)
And, hence, we obtain
 rU  8%
18
18
18
18
V 



 $59.62 mln
2
3
4
1.08 1.08 1.08 1.08
L
0
Now we have to compute the interest tax shield
0.73 0.57 0.39 0.20
PV ( Interest Tax Shield) 



 $1.63 mln
2
3
4
1.08 1.08 1.08 1.08
VL = VU + PV(Interest Tax Shield) =
$61.25 mln
NPV = 61.25 – 28 = $33.25 mln
Exactly the same answer as using WACC!