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DEBT vs. EQUITY AND ASYMMETRIC INFORMATION: A REVIEW Linda Schmid Klein, University of Connecticut Thomas J. O Brien*, University of Connecticut Stephen R. Peters, University of Cincinnati March 2002;
DEBT vs. EQUITY AND ASYMMETRIC INFORMATION: A REVIEW Linda Schmid Klein, University of Connecticut Thomas J. O Brien*, University of Connecticut Stephen R. Peters, University of Cincinnati March 2002; Forthcoming, The Financial Review *Corresponding author: Department of Finance, University of Connecticut, 2100 Hillside Rd., Storrs, CT ; Phone: (860) ; Fax: (860) ; Acknowledgements: The authors thank Ivan Brick, Shanta Hegde, Tim Manuel (especially), and Steve Wyatt for reading the paper and for insightful comments. Abstract: Recent Nobel Prizes to Akerlof, Spence, and Stiglitz motivate this review of basic concepts and empirical evidence on information asymmetry and the choice of debt vs. equity. We first review the literature that holds investment fixed. Then we review capital structure issues related to the adverse investment selection problem of Myers-Majluf. Finally, we discuss the timing hypothesis of capital structure. Empirical studies do not consistently support one theory of capital structure under information asymmetry over the others. Thus, the review suggests that additional theoretical contributions are needed to help understand and explain findings in the empirical literature. Keywords: capital structure, asymmetric information, pecking order hypothesis, timing hypothesis JEL Classifications: G30/G32 Debt vs. Equity and Asymmetric Information: A Review 1. Introduction George Akerlof, Michael Spence, and Joseph Stiglitz received the 2001 Nobel Prize for introducing an enduring set of tools to examine the economic impact of asymmetric information. The tools have been used to open vast research agendas in many areas of economics, including corporate finance. In corporate finance, asymmetric information refers to the notion that firm insiders, typically the managers, have better information than do market participants on the value of their firm s assets and investment opportunities. This asymmetry creates the possibility that the market will not price the firm s claims correctly, thus providing a positive role for corporate financing decisions. In this paper we review the impact of asymmetric information on one specific area of corporate finance, the choice of capital structure claims in terms of debt versus equity. As Riley (2001) notes in his general review, capital structure is a topic that has been dramatically affected by the rigorous consideration of information asymmetry. As one part of a comprehensive review of (nontax-driven) capital structure theories, Harris and Raviv (1991) discuss the most important developments in asymmetric information and capital structure, observing that up to that time theoretical research on the topic had reached a point of diminishing returns. However, there has been considerable research in this area since then, especially on the empirical side. We revisit and update the topic in this article. We do not review asymmetric information topics other than 1 those related to the basic choice between debt and equity, nor do we review capital structure topics other than those related directly to asymmetric information. Our review updates the discussion of the choice of debt versus equity in an asymmetric information environment by using a broad overview of the theory and empirical results. We summarize the theoretical contributions. Our review of the empirical literature is generally limited to a summary of the main results and their interpretations. Rather than attempting to include all the relevant work, we discuss a representative sampling that can provide an understanding of recent developments in this area. Our review is organized as follows. In Section 2, we summarize the groundwork laid by the 2001 Nobel laureates. In Section 3 we first summarize the Ross (1977) model illustrating how mispriced equity gives managers the incentive to signal the market their private information through capital structure decisions. We then touch on the main ideas contained in other capital structure signaling models in which investment is fixed. We also review some of the empirical findings related to these models. Section 4 extends the connection between signaling and leverage by examining the pecking order model in Myers and Majluf (1984). They endogenize the firm s investment decision and demonstrate that managers, acting in shareholders' best interests may pass up positive net present value (NPV) investments if the equity necessary to finance them is sufficiently underpriced by the market. We then discuss subsequent theoretical models of firms financing and investing decisions, and the implication for the choice between debt and equity. We also review some of the empirical tests related to the pecking order hypothesis. Section 5 reviews the theory and evidence on the timing hypothesis of capital structure choice. Section 6 summarizes and concludes the review. 2 2. Foundations of capital structure and asymmetric information Modigliani and Miller (1958) establish the foundation of capital structure theory and demonstrate that in a world of fully informed investors, no taxes, and risk-free debt, firm value and in particular, equity value is determined without regard to the firm s capital structure. They are rightly credited for this irrelevance result, but the term irrelevant does not appear in the 1958 article in the context of financing decisions. To the contrary, Modigliani and Miller identify where relevance might be found in capital structure decisions by looking at market frictions, including the potential impact of asymmetric information: That grounds for preferring one type of financial structure to another will still exist within the framework of our model can readily be seen for the case of common stock financing. In general, except for something like a widely publicized oil-strike, we would expect the market to place very heavy weight on current and recent past earnings in forming expectations as to future returns. Hence if the owners of a firm discovered a major investment opportunity which they felt would yield much more than [the cost of capital], they might well prefer not to finance it via common stock at the then ruling price, because this price may fail to capitalize the new venture. (p.292) Thus, Modigliani and Miller argue that asymmetric information makes retained earnings and debt better financing tools than new equity when the equity is underpriced. They do not discuss the potential implications of bankruptcy in their asymmetric information scenario, but the intuition appears straightforward. In the presence of bankruptcy costs, there is a limit to how much risky debt can be issued before new equity is preferred to issuing any more risky debt. The larger a project s unrecognized NPV, the higher will be that limit, all else equal. Firms with a higher level of unrecognized NPV will have more incentive to issue debt rather than new equity. Unlike Ross (1977), Myers and Majluf (1984), and others that followed, Modigliani and Miller did not have the asymmetric information theory developed by the Nobel laureates of Thus, Modigliani and Miller do not suggest that managers signal their information through financing decisions, or that asymmetric information might prevent managers from accepting 3 positive NPV projects. [Stiglitz (1969, 1974), in his generalization of the Modigliani and Miller theory, appears to be the first to note that financial policies may convey information on firms prospects.] Asymmetric information theory, pioneered by the 2001 Nobel laureates, introduced the concept of adverse selection. When contracting with an agent with superior information, an uninformed agent faces the consequences of adverse selection because he does not know if the relevant characteristics of the informed agent are good or bad. To demonstrate the adverse selection problem, and how signaling can resolve it, Akerlof (1970) used the lemons market for used cars to illustrate how sellers of good quality cars can use a warranty to signal quality to buyers who cannot otherwise distinguish between good cars and lemons. Absent a means for buyers to distinguish the quality of a used car, the equilibrium used car price will be the expected value of a used car. This is a pooling equilibrium, because the average price is paid for cars of varying quality (value) that are indistinguishable. In a pooling equilibrium, sellers of lemons are big winners, sellers of good cars are big losers, and buyers are indifferent. Thus, the cost created by the information asymmetry is borne entirely by the good quality car sellers. Clearly, the seller of a good quality car would benefit by conveying, or signaling, the car's quality to buyers. The owner of a lemon will also wish to represent the quality of his car as good. Therefore, the signal must be credible if it is to be capable of allowing buyers to identify a used car s quality. In game-theoretic terminology a credible signal is incentive compatible. In other words, a credible signal is one that the owner of a lemon has no incentive to attempt to mimic. To credibly signal quality, the seller of a good quality car can offer a warranty. There are two conditions that the warranty must satisfy to create a separating equilibrium, in which buyers pay a higher price for a higher quality used car. The first condition is incentive 4 compatibility: the lemon owner must not have the incentive to offer the same warranty as the owner of a good car. The second condition is individual rationality, which ensures that the seller of a good quality car is in fact better off in the separating equilibrium than in the pooling equilibrium. In the used car market, a warranty is a credible signal of quality because a sufficiently large warranty is too expensive to be attractive to sellers of lemons, because they are more likely to have to pay the warranty. In this type of asymmetric information model the informed agent moves first, and the separating equilibrium is more commonly known as a signaling equilibrium. The term separating equilibrium is generally used in models in which the uninformed agent moves first by offering a menu of incentive compatible choices (contracts) from which the informed self-select, revealing their private information through their choice. As an example, compare the analysis of a signaling equilibrium in Akerlof or Spence (1973) with that of the separating equilibrium in Rothschild and Stiglitz (1976). 3. Leverage signaling with investment fixed 3.1. The Ross model In the Ross (1977) model, we see the intuition of Akerlof (1970) as it applies to capital structure. Ross illustrates that managers with an informational advantage have an incentive to signal their private information through their choice of debt level. Firms with lower expected cash flows find it more costly to incur higher levels of debt (because bankruptcy is more likely) than do firms with higher expected cash flows. Just as sellers of lemons find a large warranty too costly, managers of firms with low expected cash flows find a relatively high level of debt too costly because it imposes a high probability of bankruptcy. Thus, high-valued firms can signal this information to the market by issuing a sufficiently high amount of debt. 5 To see how the Ross signaling model works, assume there are two firms, good (G) and bad (B). During the next period, firms realize a cash flow ~ x, where the density function f t ( x ) t is uniform on the interval [ 0,x ], t = G, B. The cash flow distributions are ordered by firstorder stochastic dominance ( x G B x ). The market knows the distributions of cash flows, but cannot distinguish firm G from firm B because the firms are identical in all other respects. By pooling firms, the market undervalues the good firm and overvalues the bad firm, so the good firm would like to convey its quality to the market. Conversely, the bad firm would prefer to hide amidst the uncertainty. One key difference between the Ross signaling model and Akerlof s is the objective function. In the example of the used car market, the sellers objective is to maximize their profits. The objective function that Ross uses is the manager s wage. Ross assumes this wage has two components. One is a function of firm value, and the other is a bankruptcy penalty. This penalty is a cost the manager incurs (separate from any bankruptcy costs the firm may incur) if the firm goes bankrupt. The manager s objective is to choose the firm s level of debt, D, to maximize his wage. Suppose that managers have the following wage contract: W t t D t t = α V ( D ) L f ( x )dx. (1) 0 0 t The first term is a positive scalar times the current market value of the firm, V0 ( D ), which is a function of the face value of debt, t D, that the firm t issues. This term reflects the fact that the market uses the firm s debt level as a signal of firm value, which is the same as used car buyers using the seller s warranty as a signal of car quality. The second term is the bankruptcy penalty, t t L, times the likelihood of bankruptcy, F ( D ). The incentive compatibility condition requires 6 G D 0 α 0 0 G B B B α V ( D ) L f ( x )dx V ( D ) L f ( x )dx. (2) The left-hand side of this condition is manager B s wage if he chooses D 0 B G D, the debt level chosen by manager G. The right-hand side is his wage if he chooses not to mimic. Because debt is personally costly to managers, in a separating equilibrium G * D = D will be the lowest debt level B sufficient to satisfy incentive compatibility. Also, D = 0 because any debt level above this, but strictly less than * D, imposes a cost on the B manager while still revealing his firm s type to the market. Finally, in a separating equilibrium, the market correctly identifies and thus correctly values, the firms. We can rearrange the incentive compatibility condition and make some substitutions to interpret the requirement for The last condition tells us that if D * * D : B * L f ( x )dx α [V0( D ) V0( 0 )] (3) 0 B * xg xb LF ( D ) α (4) 2 * D is set so that firm B manager s expected bankruptcy penalty from financing with D * outweighs the gain in wage from being perceived as firm G, then incentive compatibility results Other leverage signaling models Another fundamental signaling model is that of Leland and Pyle (1977), in which insider ownership provides the signal of firm quality. Under certain conditions, managers of high-quality firms signal their type by retaining a high proportion of ownership, and therefore finance with higher levels of debt than managers of low-quality firms. Financing with debt allows a manager to retain a larger ownership stake in the firm, but the larger equity stake is costly to a risk-averse manager. The fact that a larger equity stake is less costly to a manager of a high-quality firm 7 drives the incentive compatibility of the signal. As in Ross (1977), the Leland and Pyle model predicts a positive correlation between firm quality and leverage. Heinkel (1982) devises a model of debt signaling in which the information asymmetry is about both the mean and the variance of returns. The assumed (positive) relations between mean and variance drives a signaling equilibrium in which higher-value firms signal their quality with higher debt levels. The Heinkel assumption, that more-valuable firms are also more risky, is consistent with the Ross result that more-valuable firms have a higher likelihood of default. This key assumption allows for a costless signaling equilibrium in which riskier, more-valuable firms have higher levels of debt financing. 1 This positive correlation between firm value and leverage is the same result found by Ross, but Heinkel does not assume that managers face a bankruptcy penalty. Instead, managers own the firm and they make capital structure decisions to maximize the value of their claim. In a pooling equilibrium, high-value, high-risk firms (low-quality firms in Heinkel s model) find their equity undervalued and their debt overvalued, but low-value, lowrisk firms (high-quality firms) have the opposite misvaluations. Thus, the high-value firms are attracted to the debt market and the low-value firms are attracted to the equity market. In this model, the incentive compatibility that is necessary for separation must run both ways. A lowvalue firm will not find it to desirable to mimic a high-value firm because that would require issuing more undervalued debt and less overvalued equity. Similarly, a high-value firm would not mimic a low-value firm because that would require issuing more undervalued equity and less overvalued debt. The signaling is costless because the manager/owner s utility is derived entirely 1 This assumption is not necessary for the separating equilibrium in Heinkel, but it is necessary for a costless separating equilibrium. If firm value and credit risk were negatively correlated, as in Ross, a separating equilibrium may exist provided both the incentive compatibility and individual rationality conditions are met. 8 from the firm s equity value and debt is assumed to carry no financial distress or bankruptcy costs. The information asymmetry in the Blazenko (1987), John (1987), and Ravid and Sarig (1991) models concerns only the mean return. Blazenko shows that if managers are risk averse in wealth (which is a stake in the firm s equity), then managers of high-value firms signal their type by issuing debt. Managers of low-value firms prefer to avoid the additional risk imposed on the equity claim when debt exists, and so their firms issue equity. In the pure signaling analysis of the John model, the firm pre-commits to implementing investment policies that are more risky than optimal. Ravid and Sarig build a full-information valuation model for the firm that they base on cash flows, corporate taxes, bankruptcy costs, and limited liability. In this framework, Ravid and Sarig obtain a separating equilibrium in which debt and dividends serve as signals of firm quality. These three signaling models also find a positive correlation between financial leverage and firm quality. The Brick, Frierman, and Kim (1998) model is unique, in that the information asymmetry is only about variance of returns. In this model, the authors assume risk-neutral investors, but the firm's full information value is related to return variance through limited liability and corporate taxes, all else equal. The result is a model in which, when information is symmetric, the firm s variance determines its optimal financial leverage. When information about the variance is asymmetric, a lower level of leverage signals a lower variance of firm returns, all else equal. In the signaling equilibrium, a higher-value firm has a lower debt level. This result, in which firm variance, taxes and bankruptcy costs drive differences in firm value, contrasts with the signaling models reviewed above, where differences in firm value are driven by differences in expected cash flows and where more debt signals higher quality. Although the Brick, Frierman, and Kim 9 model is instructive, lower variance usually implies other differences in firm value under risk aversion. At present, we are not aware of any debt-equity signaling model that considers asymmetric information about firm value driven (at least in part) by asymmetric information about firm risk under risk aversion. Vermaelen (1984), Persons (1994, 1997), and McNally (1999) model firms incentives to repurchase shares, holding investment fixed. In these models, better (potentially undervalued) firms repurchase shares to distinguish themselves from worse firms. The Vermaelen and McNally models use a Leland and Pyle-type managerial incentive structure. The Persons model uses a shareholder heterogeneity device. Since a share repurchase increases a firm s financial leverage, these models suggest a positive correlation between leverage and expected future cash flows Empirical evidence on lever
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