A Robustness Check on Debt and the Pecking Order Hypothesis with Asymmetric Information

Transcription

1 nternational Journal o conomics and Finance; Vol. 8, No. 6; 6 SSN SSN Published by Canadian Center o Science and ducation Robustness Check on Debt and the Pecking Order yothesis with symmetric normation George Chang Deartment o Finance, Seidman College o Business, Grand Valley State University, US Corresondence: George Chang, Seidman College o Business, Grand Valley State University, Grand Raids, M, 494, US. -mail: changg@gvsu.edu Received: March 8, 6 cceted: ril 8, 6 Online Published: ril, 6 doi:.39/ije.v8n68 UR: htt://d.doi.org/.39/ije.v8n68 bstract Daniel and itman 99 eamined the incentives o irms to signal their values rior to making a new equity oering. By analyzing this issue within a simle ramework that encomasses a number o models in the literature, they were able to judge the relative eiciency o various signals that have been roosed. lthough their analyses oer valuable insights, the robustness o their model has yet to be checked. his aer eamines the arametric assumtions o their model in the section on debt and the ecking order hyothesis. We irst generalize the assumtions in the eamle by Daniel and itman 99 to allow or continuous-state o nature. We then derive the resulting closed-orm solution or the equilibrium ayos to the original shareholders o both tyes irms under dierent belies. lthough we only eamine the robustness o a articular setting, our methodology can be alied to other settings. Keywords: inancing decisions, ecking order hyothesis, asymmetric inormation, signaling, robustness. ntroduction he objective o the manager o the irm is to maimize the terminal value o the original owners claim to the irm s assets. Giammarino and Neave 98 set u a model in which the managers and investors share the same inormation about everything ecet risk. n this case, equity issues dominate debt issues, because the only time managers want to issue debt is when they know the irm is riskier than investors think. nvestors, realizing this, reuse to buy. Only equity, or erhas a convertible security, is issued in equilibrium see Myers & Majlu, 984. Daniel and itman 99 rovides a numerical eamle that illustrates what Giammarino and Neave 98 have shown: i managers have rivate inormation about only cash low variance, then the ecking order will be reversed: irms will never issue debt. he numerical eamle in Daniel and itman 99 is reroduced in able able. Debt-issuance equilibria: Original eamle rom Daniel and itman 99 Model Parameters %. 3 u d, 3 u d 8,. 4 Var Var 6 Belie Set u d Belie Set B Don t ake: None Don t ake: ow variance ake: Both ool ake: igh variance YP Don t take ake YP Don t take ake n their setu, i the irm were to issue equity, there would be no adverse selection roblem because the ull-inormation value o a share o a tye s equity would be the same as a tye s given the assumtions o risk neutrality and equal mean o both rojects ayos. hereore, the original shareholders o both tyes 8

2 nternational Journal o conomics and Finance Vol. 8, No. 6; 6 would issue equity at the ull-inormation value and thereore cature the ull NPV o the rojects. owever, i the irm chooses to issue debt, the ull-inormation value o a tye bond would be lower, because a tye would deault more oten. n other words, i the tyes were observable, a tye would have to incur a notional debt obligation higher than the unds raised or the roject. n their eamle, it is shown that both ooling and searating equilibrium are suorted by investors belies. owever, since the ayo to the tye irm in both equilibria is lower than it would be i the irm issued equity, it is argued that tye irm would always issue equity: debt will be the dominated security. he rest o the aer is organized as ollows. Section rovides a brie review o related studies. Section 3 eamines the robustness o the results in Daniel and itman 99 by generalizing their assumtions to allow or continuous-state o nature. Section 4 concludes.. iterature Review Financing investments under asymmetric inormation is o great interest and imortance both in theory and in ractice. he inormation contents and imlications o a irm s inancial decisions have been studied theoretically and emirically. On the theoretical ront, Myers and Majlu 984 consider the imlications o adding the otion o issuing debt to the irm s strategy sace, and conclude that there eists a ecking order in the issuance o securities. n the basic Myers and Majlu model where cash lows are certain, debt would be riskless and there would be eicient investment. Brennan and Kraus 987 shows that irms with outstanding risky debt can costlessly signal their tye through inancing decisions. Narayanan 988 suggests that in a setting where the manager has rivate inormation about the mean o the distribution o the cash lows rom the irm s investment oortunity but where the variance o this distribution is common knowledge, the Myers ecking order theory still aly. Noe 988 etends Narayanan s model to a three tye eamle, and shows that an equilibrium may obtain in which low and high value irms issue debt, and medium M value irms issue equity. Giammarino and Neave 98 set u a model in which the managers and investors share the same inormation about everything ecet risk. n this case, equity issues dominate debt issues, because the only time managers want to issue debt is when they know the irm is riskier than investors think. nvestors, realizing this, reuse to buy. Only equity, or erhas a convertible security, is issued in equilibrium. Daniel and itman 99 rovides a numerical eamle that illustrates what Giammarino and Neave 98 have shown: i managers have rivate inormation about only cash low variance, then the ecking order will be reversed: irms will never issue debt. 3. Generalization and Robustness Check o eamine the robustness o the results in Daniel and itman 99, we generalize the assumtions in their eamle by allowing or continuous-state o nature. Seciically, the random ayos o the rojects or both tyes irms are assumed to be normally distributed with same mean but dierent variances. Note that although the ayos are assumed to be normally distributed, in all the derivations o shareholder/bondholders value, aroriate structures were imosed to make limited liability eective throughout. We then derive the resulting closed-orm solution or the equilibrium ayos to the original shareholders o both tyes irms under dierent belies. Details o the derivation are rovided in the endices. able resents the result using our continuous-state setting but with the same original arameters as in Daniel and itman 99. able. Parameters %. 3 ~ N μ, N, σ ~ 6 Note. Some arameters as in the original eamle, but with normally distributed roject ayos. 4 Belie Set Belie Set B Don t ake: None Don t ake: ow variance ake: Both ool ake: igh variance YP Don t take ake YP Don t take ake

3 nternational Journal o conomics and Finance Vol. 8, No. 6; 6 Given the derived ormulae, the robustness o Daniel and itman s conclusion to various arameters values in continuous-state setting can be easily eamined. We ound that their results are surrisingly robust to arameters values. owever, one should kee in mind that this robustness is with resect to the arameters values only, because we are constraining in our model that debt and equity are the only instruments or inancing the roject. n the more realistic scenarios where other tyes o securities can also be used, the story will be a whole lot dierent rom the simle ecking order or reverse ecking order theory. Figures through 6 lot the values o interest rom sensitivity analysis or each arameter. From each grah, we can easily determine any suorted equilibrium/equilibria, and the relevant tye irm s inancing decision. Remarks on each o the Figures are rovided ollowing the Figures. 3 B B D D Figure. Sensitivity analysis with resect to robability o tye- irm Note. For all values o, searating equilibrium is suorted. Roughly seaking, or >=.4, ooling equilibrium is suorted. or tye irm, equity issuance dominates debt issuance. owever, B B D D / Figure. Sensitivity analysis with resect to -/ Note. For all values o -/, ooling equilibrium is suorted. Roughly seaking, or -/ >, searating equilibrium is suorted. owever, or tye irm, equity issuance dominates debt issuance. 83

4 nternational Journal o conomics and Finance Vol. 8, No. 6; 6 B B D D NPV + Figure 3. Sensitivity analysis with resect to NPV+ Note. For all values o NPV+, ooling equilibrium is suorted. Roughly seaking, only or NPV+ <=4, searating equilibrium is suorted. owever, or tye irm, equity issuance dominates debt issuance. Figure 4. Sensitivity analysis with resect to var Note. For all values o var, ooling equilibrium is suorted. Roughly seaking, or var<=6, searating equilibrium is suorted. owever, or tye irm, equity issuance dominates debt issuance. B B D D var Figure. Sensitivity analysis with resect to var Note. For all values o var, ooling equilibrium is suorted. Roughly seaking, or var>=6, searating equilibrium is suorted. owever, or tye irm, equity issuance dominates debt issuance. B B D D var 84

5 nternational Journal o conomics and Finance Vol. 8, No. 6; B B D D Var / var Figure 6. Sensitivity analysis with resect to var/var Note. For all values o var/var, ooling equilibrium is suorted. Roughly seaking, or var/var<=., searating equilibrium is suorted. owever, or tye irm, equity issuance dominates debt issuance. Notations or Figures through 6: B = -tye irm shareholders eected ayos under belie set. ooling B = -tye irm shareholders eected ayos under belie set. ooling D = -tye irm shareholders eected ayos under belie set B. searating D = -tye irm shareholders eected ayos under belie set B. searating = sset-in-lace. is also the value o the shareholders i the irm does not take the roject. = he value o the old shareholders i the roject is inanced by equity. is the benchmark or irm s decision o whether to issue debt or equity. = robability o tye- irm = roject investment NPV = net resent value o the roject Var= variance o irm roject s ayos Var= variance o irm roject s ayos 4. Conclusion Daniel and itman 99 eamined the incentives o irms to signal their values rior to making a new equity oering. By analyzing this issue within a simle ramework that encomasses a number o models in the literature, they were able to judge the relative eiciency o various signals that have been roosed. lthough their analyses oer valuable insights, the robustness o their model has yet to be checked. his aer eamines the arametric assumtions o their model in the section on debt and the ecking order hyothesis. We irst generalize the assumtions in the eamle by Daniel and itman 99 to allow or continuous-state o nature. We then derive the resulting closed-orm solution or the equilibrium ayos to the original shareholders o both tyes irms under dierent belies. We ound that their results are surrisingly robust to arameters values. lthough we only eamine the robustness o a articular setting, our methodology can be alied to other settings, which is the major contribution o this aer to the eisting studies. Reerences Brennan, J., & Kraus, icient Financing Under symmetric normation. Journal o Finance, 4, -43. htt://d.doi.org/./j tb

6 nternational Journal o conomics and Finance Vol. 8, No. 6; 6 Cadsby, C., Frank M., & Maksimovic V. 99. Pooling, searating, and semisearating equilibria in inancial markets: Some eerimental evidence. Review o Financial Studies, 33, htt://d.doi.org/.93/rs/3.3.3 Cadsby, C., Frank M., & Maksimovic, V quilibrium dominance in eerimental inancial markets. Review o Financial Studies,, htt://d.doi.org/.93/rs/..89 Chemmanur,., & Fulghieri, P theory o the going-ublic decision. Review o Financial Studies,, htt://d.doi.org/.93/rs/..49 Daniel, K., & itman, S. 99. Financing investment under asymmetric inormation. n R. Jarrow, V. Maksimovic, & W. Ziemba ds., andbooks in Oerations Research and Management Science, Finance Vol. 9, North-olland, msterdam. htt://d.doi.org/.6/s Dasguta, S., & itman, S Pricing strategy and inancial olicy. Review o Financial Studies, 4, htt://d.doi.org/.93/rs/.4.7 Fluck, Z Otimal inancial contracting: Debt versus outside equity. Review o Financial Studies,, htt://d.doi.org/.93/rs/..383 Giammarino, R., & Neave,. 98. he ailure o inancial contracts and the relevance o inancial olicy. dministrative Sciences ssociation o Canada, Proceedings. Myers, S., & Majlu, N Cororate inancing and investment decisions when irms have inormation that investors do not have. Journal o Financial conomics, 3, 87-. htt://d.doi.org/.6/ Narayanan, M Debt versus equity under asymmetric inormation. Journal o Financial and uantitative nalysis, 3, 39-. htt://d.doi.org/.37/333 Noe, Caital Structure and Signaling Game quilibria. Review o Financial Studies, 4, htt://d.doi.org/.93/rs/.4.33 Stiglitz, J. 98. On the irrelevance o cororate inancial olicy. merican conomic Review, 63, endi Polling Notional Debt Obligation rob. o - tye rob. o - tye asset -in - lace o - tye asset -in - lace o - tye roject investment required NPV eected value net o o the roject's cash lows eected random ayo random ayo value o the roject's gross cash lows o the roject rom - tye o the roject rom - tye CDF o PDFo CDF o PDFo NPV ~ N, ~ N, 86

7 nternational Journal o conomics and Finance Vol. 8, No. 6; 6 87 d d d d rob rob,] ma[ and,] ma[,] ma[, ma : that Note, ma, ma solvent, ma deault solves debt obligation notional ooling d d 3 where d d lower truncated mean o a is lower truncated mean o a is Similarly,, ma 4 : deine into, and 4 and 3 Plug

8 nternational Journal o conomics and Finance Vol. 8, No. 6; 6 88 have We * * endi B Old shareholder s eected value i the irms take the roject while under belie set Set under Belie eected value shareholde rs' s old - tye irm' Set under Belie eected value shareholde rs' s old tye irm' - debt obligation notional debt with issue irms o both tyes Set : Belie B B d d B, ma, ma d d - 6, ma Similarly, where B d - 7 where d

9 nternational Journal o conomics and Finance Vol. 8, No. 6; 6 endi C Old shareholder s eected value i the irms take the roject while under Belie Set B Belie Set B : - tye does not take the roject. - tye takes the roject by issuing debt with notional obligation N D D - - tye tye irm' s old shareholde rs' eected value irm' s old shareholde rs' eected value under Belie Set B under Belie Set B N can be obtained by setting in equation, ence, By the same derivations as in 6 and 7, we have N D ma N, - N N N 8 9 nd where and D ma, - N N N N N N N d d N Coyrights Coyright or this article is retained by the authors, with irst ublication rights granted to the journal. his is an oen-access article distributed under the terms and conditions o the Creative Commons ttribution license htt://creativecommons.org/licenses/by/3./. 89