o Moral hazard o Adverse selection Why do firms issue claims on the capital market?

Transcription

1 Cororate finance under asymmetric information Two ig information rolems o Moral hazard o Adverse selection Why do firms issue claims on the caital market? o financing investments o for risk-sharing reasons o cashing in and moving on o trying to sell overvalued assets to investors Asymmetric information etween insiders and investors o The lemons rolem: adverse selection market reakdown cross susidization o Good orrowers may find it difficult to searate themselves from ad ones o Stock rices react negatively to equity offerings An equity offering could indicate overvalued assets Share issues are ad signals aout rofits Conversely, share uyacks are good signals o The ecking-order hyothesis internal finance f det f hyrid caital f equity o Distorted contracts may signal good orrowers qualities. nvesting too little too late, etc. Tore Nilssen Economics of the irm Set 6 Slide 1

2 o How to uild a theory Who are the insiders? And what are their ojectives? Managers? Current owners? Which contracts are offered? Who moves first the informed or the uninformed? o Who knows what? Signalling vs screening. Here: stick to insiders having rivate information Some outside investors etter informed than others? Outsiders having information that insiders don t have? nsiders information affecting also third arties? A firm may want to tell the caital market aout high market demand, ut does not want otential cometitors to know. A simle model: rivate information aout rosects Borrower has no funds: A = 0. nvestment costs. Risk neutrality. Limited liaility. Cometitive caital market. No moral hazard: B = 0. Project returns R if successful, 0 otherwise. The orrower is one of two tyes: either good with success roaility, or ad with success roaility q, where > q, and R >. Tore Nilssen Economics of the irm Set 6 Slide 2

3 Two cases o Only the good tye is creditworthy: R > > qr. o Both orrower tyes are creditworthy: R > qr >. The orrower knows her own tye. Outside investors elieve she is good with roaility α and ad with roaility 1 α. nvestors rior success roaility: m = α + (1 α)q Contract: R what orrower receives if success; 0 if failure. Benchmark: Symmetric information. G o Good orrower receives R, holding investors at G reakeven: (R R ) = o f ad orrower is creditworthy (qr > ), then she receives R such that q(r R ) =. B B o Good orrowers get higher returns: R > R G B Asymmetric information: o Stick to the simle contract: R. o nvestors cannot tell good orrowers from ad ones. o Breakeven: m(r R ) Tore Nilssen Economics of the irm Set 6 Slide 3

4 o No lending if mr <. Haens if ad tye is not creditworthy (qr < ) and exected overall rofitaility is low: [α + (1 α)q]r < α < α* = ( R ) q q Underinvestment good orrowers do not get financing, even though they have rofitale rojects. o Lending if mr. Haens either if oth tyes are creditworthy, or if the ad tye is not, ut α α*. Breakeven constraint inding: R = R m Cross-susidization investors lose money on ad orrowers and make money on good orrowers: (R R ) > > q(r R ) Overinvestment if ad tye is not creditworthy, which haens if ( R) α q /R α Tore Nilssen Economics of the irm Set 6 Slide 4

5 o A measure of adverse selection Lending requires mr q 1 ( α ) R [1 χ]r, where: χ = ( 1 α ) q Good orrowers ledgeale income R is discounted y the resence of ad orrowers. The rolem of adverse selection is increasing in the roaility of the ad tye, 1 α, and the likelihood ratio q. A counterart to the agency cost in the moral-hazard case. o With adverse selection, the good orrower does not receive the roject s NPV = R, conditioned on receiving financing as in the moral-hazard case. Rather, she receives R = (R m ) = (R ) χ. χ Tore Nilssen Economics of the irm Set 6 Slide 5

6 Private information aout assets in lace Suose the firm has an ongoing roject and only needs a deeening investment ut has no cash availale. As it stands with the assets in lace the firm has either a good roject with success roaility or a ad one with success roaility q. The roaility of the roject eing good, as seen from outside investors, is α. f the roject is good (ad), then the firm is undervalued (overvalued). A deeening investment increases the success roaility for oth roject tyes with τ, such that τr >. But contracts cannot e ased on this investment in isolation. Would the firm want to issue new shares in order to otain funds for the deeening investment? o An entrereneur with good assets in lace is less willing to let new investors in than is one with ad assets in lace. Pooling vs searating equilirium o n a ooling equilirium, the tyes ehave identically and offer outside investors identical contracts. o n a searating equilirium, the tyes ehave differently and offer outside investors different contracts. Breakeven constraint in a ooling equilirium [α( + τ) + (1 α)(q + τ)]r l = R l = m +τ Tore Nilssen Economics of the irm Set 6 Slide 6

7 Good firm s incentive constraint in a ooling equilirium: o t must e etter to carry out the deeening investment with the financing terms in the market than to kee the roject as it is now. + τ ( + τ)(r R l ) R τr m + τ χτ τr, χ τ where: χ τ = ( α )[( + τ ) ( q + τ )] = ( α )( q ) + τ + τ o Tye-deendent reservation utility: The etter roject the firm has, the higher value it gets from simly staying out of the caital market. o The deeening investment must not only e rofitale, ut sufficiently so, since τ χ o The good tye invests if χ τ is strictly ositive. the deeening investment is very rofitale, or there is little adverse selection (χ τ is low). n a ooling equilirium, oth tyes invest and carry out an equity offering. The total value of the firm after the investment, as seen from the outside, is (m + τ)r. o No stock-market reaction to the equity offering, since it is uninformative. Tore Nilssen Economics of the irm Set 6 Slide 7

8 + τ f τr <, then m + τ o the good tye would not invest in a ooling equilirium o no ooling equilirium exists o the only equilirium is a searating one, where the firm, if it is of good tye, does not invest. o the outside investors, if oserving an equity offering, understand that this must come from a ad tye and require B a higher stake: R = q +τ o there is a negative stock rice reaction to an equity offering: efore the announcement, the value of the firm to outside investors is V 0 = α[r] + (1 α)[(q + τ)r ] after the announcement, the value is V 1 = (q + τ)r there is a fall in this value if R > (q + τ)r ut we know already that R > ( + τ)(r ) > ( + τ)(r m +τ > (q + τ)(r ) = (q + τ)r q +τ ) q +τ o The ooling equilirium is more likely to exist in good times, when τ is high and/or low: Stock-rice reactions should on average e less negative in ooms. Tore Nilssen Economics of the irm Set 6 Slide 8

9 The ecking-order hyothesis: det is referale to new equity Myers and Majluf (1984) Again: in order to discuss det vs equity in a simle model, it is necessary to introduce a salvage value: return if failure is R, if success R S = R + R, where 0 < R <. No assets in lace: A = 0; so rivate information is aout rosects. Suose mr S + (1 m)r > ; there will e lending even if investors cannot tell good tye from ad. Contract: { R, S R } what the orrower gets if success, failure. Breakeven constraint of outside investors: m(r S S R ) + (1 m)(r R ) = Exected rofit of a good orrower: R + (1 ) R S n the otimal contract, the good orrower wants to commit all the salvage value as safe det to investors, ecause this decreases the adverse-selection rolem. o A decrease in sustain an increase in R makes the outside investors ale to S R at a rate the good orrower s rofit at a rate m m, which will increase > m m. o The equilirium contract: { R, S R } = {R R m, 0}. Tore Nilssen Economics of the irm Set 6 Slide 9

10 mlementation of the contract. o irst, a det oligation D = R. This is safe det, since the firm will always have at least R to ay its det. o Seondly, an equity issue, where shareholders get a fraction R l /R of rofits in excess of R, where mr l = D, or: R l = D m = R m Adverse selection entails cross-susidization from good to ad orrowers. ssuing det minimizes this cross-susidization and therefore minimizes the adverse-selection rolem for a good orrower. More generally, the good orrower would want to issue lowinformation-intensive claims to mitigate the adverse selection rolem. o The more sensitive the investors claims are to the orrower s rivate information, the higher returns they demand from a good orrower to cover for the losses on a ad one. o Some modifications nsurance needs for a risk-averse entrereneur: who is most needy of service the good tye or the ad tye? nformation-intensive claims are etter for value measurement, imroving incentives to create value and making it easier for the entrereneur to exit in case of a liquidity shock. f there is rivate information aout the roject riskiness, then the est solution may e some hyrid claim, such as convertile det. nvestors with market ower.. Tore Nilssen Economics of the irm Set 6 Slide 10

11 Dissiative signals Costly ways for the good orrower to searate from ad ones without having to astain from investment altogether. Disclosure of verifiale information. Certification: uying the services of a certification agency, such as a rating agency, an auditor, etc. o Suose mr >, so that the good orrower gets funding, ut is concerned y cross-susidization. o Without certification, orrower gets R in case of success, where m(r R ) =, so that R = R. m o Certification costs c, needs to e covered out of the investment. o Bad orrower would never uy certification. o With certification, good orrower gets return G (R R ) = + c. G R, where o Good orrower uys certification if and only if G R > R R + c > R m c + c < χ o Certification ays off if its costs are small relative to the extent of the adverse-selection rolem. Collateral as a costly signal of rivate information o A good-tye orrower may use collateral in order to tell the outside investors aout her tye. t is more exensive for a ad tye to ledge collateral, since the roaility of failure, and therefore loss of the collateral, is greater for the ad tye than for the good tye. Tore Nilssen Economics of the irm Set 6 Slide 11

12 o Suose that without rivate information, even the ad-tye would receive funding: qr > 0; and a collateral of value C to the firm only returns βc to an outside investor, where 0 β < 1. o Contract with collateral: {R, C}. o The good-tye orrower maximizes her exected rofit suject to two constraints: reakeven among investors, and a mimicking constraint stating that it is etter for a ad-tye orrower not to offer this contract, even if this reveals her tye, than to mimic the good tye and suffer the risk of losing the collateral. o ormally, the good-tye orrower solves max R ( )C { R, C} suject to (R R ) + (1 )βc qr (1 q)c qr o Both constraints are inding in equilirium. The solution is found y solving the equation system where oth constraints hold with equality: { R *,C * } = {R β q βq q Tore Nilssen Economics of the irm Set 6 Slide 12, 1+ ( β ) 1 q q * o Here, R > R (/), the good orrower s return in case of success without rivate information. The equilirium contract with rivate information makes use of oth the ad-tye orrower s greater concern for losing collateral and her smaller interest in return if success. }

13 o Determinants of collateral: C* = 1+ ( β ) 1 q q Cheaer collateral imlies that more collateral needs to e ledged: C*/ β > 0. f the cost of collateral decreases, in the sense that βc (the outsiders valuation of the collateral) gets closer to C (the orrower s valuation), then the good-tye orrower needs to rovide more collateral in order to scare off the ad tye. The stronger the asymmetry of information is, the more collateral is needed: C*/ q < 0. ixing the quality of the good tye,, outsiders get more concerned aout the orrower s tye when q is small. o Testale imlication: good firms ledge more collateral than ad firms. The oosite imlication of what the moral-hazard theory has. Emirical studies exist suorting moral hazard as an information-ased exlanation for collateral. o Other ways of signalling a firm s high quality to investors: More short-term det than called for without rivate information aout the roaility of reinvestment needs. This reduces the good (low-roaility) firm s chances of continuation, ut increases its return in the event of continuation and eventual success. More dividend aid out than otherwise called for, in order to signal a firm s strength. Tore Nilssen Economics of the irm Set 6 Slide 13