Unit 6

Question 1

Stylized facts

Answer 1

• Equity issuance is rare
• Managers claiim that they first access retained earnings => debt => outside =>equity
• More profitable firms have lower debt equity ratios
• At the announcement of an equity issue there is a significant price drop
• There’s instability in capital structure

Question 2

Pecking order theory: Myers & Majluf

Answer 2

• It tries to explain debt and equity issuance rather than the equilibrium lebels of debt
• There’s adverse selection in the equity issuance beause of asymmetric information
  
  • Equity issuance is a signal of low quality
• Managers act in the interest of initial shareholders

Question 3

Model assumptions

Answer 3

• 2 dates, risk neutral investors, zero riskless rate
• Continuum of firms characterized by cashflows of assets in place
• All firms have an identical NPV investment oportunity
• Firms have no cash
• Initial shareholders do not buy the new shares if issued

Question 4

Myers and Majluf predictions

Answer 4

• Only low quality firms find it optimal to issue equity
  
  • Announcement of equity issuance produces an adverse price reaction to the issuance of equity
• Financial slack ameliorates the adverse selection problem
• If firms can fund the investment with securities whose valuation is less sensitive to theta the problem is less severe
  
  • Riskless debt> risky debt>prefered stock>common stock
• Underlying dilution problem vanishes if initial shareholders acquire new shares in proportion to their initial holdings

Question 5

Empirical implications

Answer 5

• Reluctance to issue new equity and equity like securities
• Pecking order behavior
• There’s no optimal debt/equity ratio
• Investmeent is sensitive to measures of financial slack