term 2- lecture 3 Flashcards
how can leverage of a company help with credibility>
when managers cannot communicate to an investors the good prospects of their firm, they can signal or reveal this information by increasing the leverage of a company
what is the credibility principle?
claims in ones self interest are credibile only if they are supported by actions that would be too costly to take if the claims were untrue. ie actions speak louder than words
how can a firm signal with debt?
assume a firm has a large new profitable project but cannot discuss the project due to competitive reasons. one way to credibily communicate the positive information is to commit the firm to large future debt payments. if the information is true, the firm will have no trouble making the debt payments. if the information is false, the firm will have trouble paying its creditors. financial distress will be costly for the firm and the manager
what is the signalling theory of debt Ross (1977)
two types of firms High and low quality. the investors know that 40% of the firms in industry are high attaining a V_H =100 and 60% are low attaining value V_L=50. the interest rate is 0. the manager knows the type of firm but investors dont. the signal: managers use debt level D to reveal type of firm to the investor. the managers compensation M is a percentage w_0 of V_0 and a percentage w_1 of future value of firm V_1. no financial distress occurs when V1 is greater than D and financial distress is when V1 is less than D. firms value decreases by C the penalty for financial distress. therefore the managers compensation is M=w_0*V_0 +w_1(V_1 - C)
what is a seperating equilibrium?
the seperating equillibrium is an equillibrium in which the managers of a high value firms carry levels of debt that the managers of low value firms find unprofitable to take on
what is the seperating equillibrium for the Ross(1977)
let D= V_L be the highest amount of debt that firms type L can carry without going into bankruptcy. signal D>D for H firms and D<D* for L firms. if a type H takes on low levels of debt then investors will think the firm is low quality. the manager prefers high levels of debt if w_0V_H +w_1V_H >w_0V_L +w_1V_H (always satisfied)
type L firm managers prefer low levels of debt if w_0V_L +w_1V_L >w_0V_H+w_1(V_L -C) and C>(V_H - V_L)(w_0/w_1). if the cost of financial distress is large enough, managers of low quality firms will not take on as high levels of debt as high quality firms.
what is adverse selection?
the idea that when the buyers and sellers have different information, the average quality of assets in the market will differ from the average quality overall.
what is the lemons principle?
when the seller has private information about the value of a good, buyers will discount the price they are willing to pay due to adverse selection
what is an example of the lemons principle in real life?
the used car market. if the seller has private information about the quality of the car, then his desire to sell reveals the car is probably of low quality. buyers are therefore reluctant to buy except at heavily discounted prices. owners if high quality cars are reluctant to sell because they know buyers will think they are selling a lemon and offer only a low price. consequently the quality and prices of cars sold in the used car market are both low.
how does the lemons principle impact the market for equity?
suppose the owner of the start up company offers to sell you 70% of stake in his firm. he states that he is only selling to diversify although you suspect that the owner might be eager to sell the large stake because he is trying to cash out before negative information becomes public.
25
* Firms that sell new equity have private
information about the quality of the current and
future projects.
* However, due to the lemons’ principle, investors believe
that the firm is issuing equity only because the firm’s
prospects are not good.
* Investors are thus willing to buy the new equity only at
heavily discounted prices.
* Therefore, managers who know their firms’
prospects are good (and whose securities will
have a high value) will not issue new equity.
* Only those managers who know their firms have
poor prospects (and whose securities will have
low value) are willing to issue new equity.
27
* The lemons problem creates a cost for firms that
need to raise capital from investors to fund new
investments.
* If they try to issue equity, investors will discount
the price they are willing to pay to reflect the
possibility that managers have bad news.
what does the lemons principle directly imply for equity issuance
stock prices tend to decline on the announcemant of an equity issue. firms tend to issue equity when information asymmetries are minimised, such as immediately after earning announcement
what is the pecking order hypothesis?
the problem of adverse selection and the associated “lemons” market problems makes equity financing in many cases costly for firms.
according to the pecking order hypothesis, managers would prefer to fund investment by:
* first using retained earnings,
* second, debt,
* and equity only as a last resort
what are the implications for capital strucutre?
- Managers who perceive the firm’s equity is under priced will have a preference to fund investment using retained earnings, or debt, rather than equity.
- The reverse is also true: Managers who perceive the firm’s equity to be overpriced will prefer to issue equity, as opposed to issuing debt or using
retained earnings to fund investment.
