Corporate Policies In A World With Information Asymmetry

Vipin K Agrawal, Ramesh K S Rao

• Publisher: WSPC
• Year: 2015
• Topic: Biological Sciences
• eBook ISBN:
  9789814551328
• Subtopic: Science General
• Index: Biological Sciences

A corporate manager typically oversees several ongoing projects and has the opportunity to invest in new projects that add wealth to the stockholders. Such new projects include expanding the corporation's existing business, entering into a new line of business, acquiring another business, and so on. If the firm does not have sufficient internal capital (cash) to finance the initial investment, the manager must enter into a transaction with outside investors to raise additional funds.

In this situation, the manager of a public corporation faces two key decisions:

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• Should he transact with outside investors and raise the necessary capital to invest in the project? The answer to this question determines the firm's investment policy.
• If the manager decides to raise external capital how should the investment be financed — with debt, with equity, or with some other security? The answer determines the firm's financing policy.

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Modern corporate finance theory, originating with the seminal work of Merton Miller and Franco Modigliani, has demonstrated that these decisions depend on the information that the manager and investors have about the firm's future cash flows.

In this book, the authors examine these decisions by assuming that the manager has private information about the firm's future cash flows. They provide a unified framework that yields new theoretical insights and explains many empirical anomalies documented in the literature.

A corporate manager typically oversees several ongoing projects and has the opportunity to invest in new projects that add wealth to the stockholders. Such new projects include expanding the corporation's existing business, entering into a new line of business, acquiring another business, and so on. If the firm does not have sufficient internal capital (cash) to finance the initial investment, the manager must enter into a transaction with outside investors to raise additional funds.

In this situation, the manager of a public corporation faces two key decisions:

-->

• Should he transact with outside investors and raise the necessary capital to invest in the project? The answer to this question determines the firm's investment policy.
• If the manager decides to raise external capital how should the investment be financed — with debt, with equity, or with some other security? The answer determines the firm's financing policy.

-->

Modern corporate finance theory, originating with the seminal work of Merton Miller and Franco Modigliani, has demonstrated that these decisions depend on the information that the manager and investors have about the firm's future cash flows.

In this book, the authors examine these decisions by assuming that the manager has private information about the firm's future cash flows. They provide a unified framework that yields new theoretical insights and explains many empirical anomalies documented in the literature.

Readership: Master and doctoral level students in finance, academic researchers and financial managers.
Key Features:

• Proposes a unified framework that contains all existing models as special cases
• Explains many empirical anomalies in the literature and provide guidance for better empirical tests

Part I

Introduction

I.1.  Background

All economic activity originates at the primitive level of a transaction between two or more parties. The terms of these transactions depend on the amount of relevant information these two parties have. Further, an empirical reality is that one party typically possesses more information than the other, that is, there is informational asymmetry (IA). Over the past four decades the literature in economics and finance has recognized this reality and has asked: How does IA affect the way business is conducted?

This fundamental question has been studied in myriad settings (e.g., education, efficiency wage theory, credit rationing, organizational design, macroeconomics) and, recently, the contributions of George Akerlof, Michael Spence, and Joseph Stiglitz in this area earned them a Nobel Prize in economics. The research on this topic has: (i) demonstrated that IA can lead to inefficiencies in a transaction and (ii) examined ways in which these inefficiencies can be minimized.

To illustrate the nature of some of the problems arising from IA, consider the used cars market which was examined by George Akerlof in the classic 1970 paper titled “The Market for ‘Lemons:’ Quality Uncertainty and the Market Mechanism.” Suppose, for simplicity, that there are two types of cars — half are of good quality (each worth $5,000) and half are of bad quality (each worth $1,000). There is IA in this market in the sense that whereas the seller of a used car knows whether the car is good or bad the buyer does not — the buyer only knows that there is a 50% chance that the car is good and a 50% chance that it is bad. Clearly, the buyer will only make an offer between $1,000 (the value of the car if it is bad) and $5,000 (the value of the car if it is good). Now, suppose that the buyer offers $3,000. The seller will reject the offer if the car is a good car and will accept the offer if it is a bad one. In this situation, the buyer will get a car worth $1,000 and will therefore lose. In fact, the only price that the buyer can offer without over-paying is $1,000 and, in this situation, the seller will sell him the car only if it is a bad one. Thus, because of IA between the buyer and the seller, the only cars that will end up being sold in the used car market are the bad ones (the “lemons”). The market for good used cars will disappear. Such a market is clearly not desirable. The research has identified mechanisms to mitigate this problem (e.g., having an authorized mechanic check the car and provide a warranty on some parts, such as the AC unit).

This simple example of IA in the used cars market can be extended to an analysis of financial decisions that the manager of a publicly-traded corporation faces when he has to raise external capital. We elaborate on this below.

A corporate manager typically oversees several ongoing projects and has the opportunity to invest in new projects that add wealth to the stockholders. Such new projects include expanding the corporation’s existing business, entering into a new line of business, acquiring another business, and so on. If the firm does not have sufficient internal capital (cash) to finance the initial investment, the manager must enter into a transaction with outside investors to raise the additional funds (“raising capital”).

In this situation, the manager of a public corporation faces two key decisions:

(i)	Should he transact with outside investors and raise the necessary capital to invest in the project? The answer to this question determines the firm’s investment policy.
(ii)	If the manager decides to raise external capital, how should the investment be financed — with debt, with equity, or with some other security? The answer determines the firm’s financing policy.

Modern corporate finance theory, originating in 1958 with the seminal work of Merton Miller and Franco Modigliani, has studied these decisions in a world where outside (new) investors and the firm’s manager have the same information about the firm — a world with “symmetric information.” In this world, managerial decisions are fairly straight-forward: (i) the manager will raise the necessary capital and invest in the positive-NPV project since there is no cost/benefit to raising external capital and (ii) it does not matter how the investment is financed because cost of external financing is zero regardless of the financing choice. Thus, the firm’s investment policy is simply to invest in all positive-NPV projects and financing policy is irrelevant.

In 1984, in a very influential paper in finance, Stewart Myers and Nicholas Majluf argued that these decisions become complicated when managers possesses more information about the firm than do the outside investors — that is, when there is IA. They demonstrated that IA can lead to a cost when raising external capital and hence to investment inefficiencies (i.e., positive-NPV projects may not get accepted by the manager). Further, they found that the firm can minimize this inefficiency (cost) through financing policy. Specifically, they found that firms can reduce the cost by following what finance researchers and textbooks commonly refer to as the pecking order theory — in raising capital, a firm first issues the least risky security, then the second least risky security, and so on. This implies that if, for exogenous reasons, only debt and equity can be issued, the firm will prefer debt over equity.

I.2.  Motivation

As in any theory, the results in Myers–Majluf’s work are derived under several assumptions. While a vast literature has developed in corporate finance that generalizes many of their assumptions, these papers have two common features: (i) they limit the set of firms to which the theory applies because they invoke arbitrary assumptions about one or more firm-specific primitives and (ii) they make limiting assumptions about the “security space.” These assumptions have limited our understanding of the impact of IA on the firm’s financial decisions. We elaborate below:

Firm-Specific Primitives: The existing literature has documented a variety of firm-specific variables that affect the manager’s financial decisions. These include the amount of funds the firm requires and, more importantly, the “nature of the manager’s private information.” The nature of the manager’s private information refers to the origin of IA. Different firms have IA originating from different sources. For example, in some firms the IA is about the value of existing assets. This means that the manager knows more about the value of these assets than outside investors. In other firms, the IA could be about the value of the firm’s new projects. In yet others, it may be about the risk of the firm’s projects.

Since the prior research makes specific and arbitrary assumptions about these firm-specific primitives (in particular about nature of the manager’s private information), the results of this research do not apply to all firms — just to those firms that satisfy those arbitrary assumptions. Some authors [e.g., Frank and Goyal (2005)] have, in fact, noted that this limitation of the theory is a potential explanation for the mixed results of the empirical tests in corporate finance.

To better understand the implications of IA, one must thus develop a theory that admits all firms, i.e., relaxes all assumptions regarding these primitives.

The “security space”: This is a list of all securities that the manager is assumed to be able to issue when he raises external funds. Since the prior research makes very specific assumptions about the security space, it cannot explain how managers and outside investors will transact when the manager can issue securities not contained in the assumed security space. Nor can it adequately identify the type of financial innovations that can help minimize the inefficiencies arising from IA.

I.3.  Scope of the Book

Although the prior research has recognized several of the limitations discussed above, it is yet to develop a theory that generalizes the assumptions about the firm-specific primitives and the security space. Accordingly, our book develops a new unifying theoretical framework that examines the manager’s financial decisions under IA for any firm under any security space. That is, our theory does not rely on specific assumptions about the firm-specific primitives or about the security space. To isolate the impact of IA on the manager’s decisions, we ignore other factors that are known to affect these decisions (taxes, bankruptcy costs, agency conflicts, etc.). Further, to simplify matters, we assume that all agents are risk neutral and that IA is static.

I.4.  Key Contributions

Our unified framework, as we will show, contains existing models as special cases. We also show that our generalization overturns several existing intuitions and yields new theoretical results about: (i) the kind of financing decisions that can minimize IA-driven investment inefficiencies, and (ii) how the manager can minimize the IA-driven inefficiencies through operational decisions and financing innovation. These new results, as we discuss, help explain many empirical anomalies documented in the literature.

Part II

Basic Setup

II.1. Overview

In our analysis, we have one-period with two-dates, t = 0 (t₀) and t = 1 (t₁). Here, t₀ represents the present and t₁ the future. Further, we have two economic entities: (i) a firm that has current investors and insufficient capital to invest in projects and (ii) outside investors who are willing to provide the firm capital. In return for this capital, outside investors are issued securities which promise them a share of the firm’s future cash flows. All market participants (current and outside investors) have limited liability and thus the most that they can lose is the value of their investment. Further, they are all risk-neutral. The risk-free interest rate is r_f.

In this part, we provide additional details regarding these economic entities and the process by which the firm interacts with the outside investors to raise capital. Chapter 1 focuses on the firm and its need for outside capital. Chapter 2 focuses on outside investors and the securities that they can be issued. Chapter 3 first describes the process by which these two entities interact and raise/supply capital, with a focus on specific decisions that the outside investors and the manager need to make. It then describes how these decisions yield implications for the firm’s financing and investment policies and its “cost (benefit) of raising capital.” Here, the cost (benefit) of raising capital is the reduction (increase) in the stockholders’ wealth when the firm raises external capital.

Chapter 1

Firm and Its
Capital Needs

1.1. Firm

At t₀, the firm is unlevered and has one or more shareholders.¹ The firm is being run by a manager whose goal is ...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Dedication
• Acknowledgement
• Contents
• Part I. Introduction
• Part II. Basic Setup
• Part III. Raising Capital When there is Symmetric Information
• Part IV. Raising Capital with Information Asymmetry
• Part V. Appendix
• References
• Index