Issuance of securities under asymmetric information

(Myers/Majluf 1984) 1. Empirical validity of the theorem of irrelevance

2. Model assumptions of the Myers/Majluf approach

3. An underinvestment equilibrium

4. A numerical example

5. The Pecking Order Theory

6. Information costs under different institutional frameworks

1. Empirical validity of the theorem of irrelevance

Price variation in response to stock emissions at US capital

markets

Average 2-day-excess returns at the time of the announcement

Kinds of stocks: Excess returns of stocks emitted by industrial firms:

Common stocks -3,14%

Preferred stocks -0,19% Convertible preferred

stocks -1,44%

Convertible bonds -2,07%

Straight bonds -0,26% Source: Quelle:Smith (1986): Investment Banking and the Capital Acquisition Process,

Journal of Financial Economics, Vol. 1, S. 5

2. Model assumptions of the Myers/Majluf approach

Characteristics of a perfect capital market 1. Same market entrance conditions for all market participants, possibility of

unlimited borrowing, short-selling, only one interest rate (borrowing rate =

lending rate)

2. No transaction costs, no tax

3. Everyone acts as a price taker

4. Symmetric and efficient information,

5. No arbitrage possibilities

Notation of Myers/Majluf (1984)

I = Investment volume of additional investment

S = Investable reserves of the firm, liquidity („financial slack“)

E = Issuing volume

P = Market value of old shares if event: no emission

P´= Market value of old shares if event: emission

a = Net present value of the present investment, as a random variable ~A ,

with market value equal to expected value A E A= (~)

b = Present value of the additional investment, as a random variable ~B ,

with market value equal to expected value B E B= (~)

Va(E) = Market value of old shares given an emission of E

Information Structure in Myers/Majluf (1984)

Time: t = -1 t = 0 t = 1

Manager’s Insider Information:

Distribution of ~A and ~B , S a, b, S

a, b, residual S

Information open to the public :

Distribution of ~A and ~B , S

Distribution of ~A and ~B , S, E

a, b, residual S

=>

Symmetric information

Asymmetric information

Symmetric information

Decision of Management

Raise capital or invest?

Pay off

3. An underinvestment equilibrium

Underinvestment in Myers/Majluf (1984)

b

Region M´: Invest and raise capital

b = (E/P´(S+a)) - E

Region M: No Investment

a = -S

a = P´-S a

b = -E

Market equilibrium given asymmetric information

Supply of stocks:

Management raises capital and invests, if

V E I S V Ea a( ) ( )= ! " = 0

=> !

! ++ + + " +

P

P EE S a b S a( )

=> E bE

PS a+ !

"+( )

Demand for stocks:

At the stock exchange, the firm receives a market price conditional on the

market participant’s perception of the distribution of a and b as well as their

knowledge of the manager’s investment strategy.

Given an emission, the market price is

! = + ! + !P S A M B M( ) ( )

with )

~()(

and ),~

()(

SIEBEMB

SIEAEMA

!="#

!="#

4. A numerical example of Myers/Majluf (1984)

state: s11 s12 s21 s22

pij: 1/4 1/4 1/4 1/4

A: 20 20 6 6

b: 4 2 4 2

Given: S = 0, I=10 and hence E = 0 or E = 10.

If the management invests in each state, it follows:

! = " = # + # + # + # =P E s( )10 1 4 24 1 4 22 1 4 10 1 4 8 16

Va11 Va

12 Va21 Va

22

Mistake 1: 20,92 19,69 (<20!) 12,31 11,07

If the management abstains from Investing in s12, it follows:

! = = = " + " + " =P E s E( , )0 10 1 3 24 1 3 10 1 3 8 1412 sonst

Va11 Va

21 Va22

Mistake 2: 19,83 (<20!) 11,67 10,50

If the management abstains from investing in s11 and s12, it follows:

! = = = " + " =P E s s E( , , )0 10 1 2 10 1 2 8 912 11 sonst

Va11 Va

12 Va21 Va

22

Investment: 9,47 8,53

No investment: 20 20

Numerical example of Myers/Majluf,

Dotted lines between M and M´ at S = 0 and S = 5

b

s21 s11

s22 s12

a

b = (E/P´(S+a))-E S=0

4

2

9 20 6

-10

b = (E/P´(S+a))-E S=5

5. The Pecking Order Theory

1. If possible, firms prefer internal financing.

2. Dividends are tried to be kept constant over time. Positive operating cash

flows should be used to reduce debt or to be invested in tradeable

securities. Negative cash flows should be compensated by raising debt or

selling tradeable securities.

3. In case of need for external financing, the firm will prefer debt over risky

equity. That is, the firm will raise capital according to the “Pecking

Order” that ranks different sources of financing, if the internal sources of

financing are depleted.

Firstly the firm will make use of

- debt (credits and bank loans, Eurobonds of different kinds), thereafter

- hybrid securities (convertible or option bonds, participation papers,

obligations), and finally

- stock emissions.

6. Information costs under different institutional

frameworks

Sources of finance of corporates from 1970-1985

(apart from financial firms) in percentage

USA UK Germany

Retentions 66,9 66,9 72,0 74,9 55,2 61,9

Capital transfers 0 2,9 6,7

Short-term securities 1,4 42,6 2,3 27,3 0 24,0

Loans 23,1 21,4 21,1

Trade credit 8,4 2,8 2,2

Bonds 9,7 0,8 0,7

Shares 0,8 0,8 4,9 4,9 2,1 2,1

Other/Statistical Adjustment

-10,2 -7,2 11,9

(Eckbo/Masulis (1995))

Price variations in response to stock emissions at the

German market Average 2-day-excess returns at the time of the announcement

Kinds of stocks: Stock excess returns of the examined companies:

Common stocks 0,89%

All option bonds 0,40% (insignificant) Option bonds cum rights

1,41% Option bonds ex new 0,10% (insignificant)

Following 30 days -1,04% (Padberg (1995), p. 235, Entrup (1995), p. 169, 181, 201)