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: Common stocks Preferred stocks Convertible preferred stocks Convertible bonds Straight bonds

Excess returns of stocks emitted by industrial firms: -3,14% -0,19% -1,44% -2,07% -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

Managers Insider Information: Information open to the public : => Decision of Management

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

Symmetric information

a, b, S Distribution of ~ ~ A and B , S, E
Asymmetric information

a, b, residual S a, b, residual S
Symmetric information

Raise capital or invest?

Pay off

3. An underinvestment equilibrium Underinvestment in Myers/Majluf (1984)

Region M: Invest and raise capital

b = (E/P(S+a)) - E

Region M: No Investment a = -S a = P-S

b = -E

Market equilibrium given asymmetric information

Supply of stocks: Management raises capital and invests, if

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

=>

P! ( E + S + a + b) " S + a P! + E
E +b ! E (S + a) P"

=>

Demand for stocks: At the stock exchange, the firm receives a market price conditional on the market participants perception of the distribution of a and b as well as their knowledge of the managers investment strategy. Given an emission, the market price is

P ! = S + A ( M !) + B ( M !)
~ A ( M #) " E ( A E = I ! S ), and ~ with B ( M #) " E ( B E = I ! S )

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

state: pij: A: b: s11 1/4 20 4 s12 1/4 20 2 s21 1/4 6 4 s22 1/4 6 2

Given: S = 0, I=10 and hence E = 0 or E = 10. If the management invests in each state, it follows:

P ! ( E = 10"s) = 1 4 # 24 + 1 4 # 22 +1 4 # 10 + 1 4 # 8 = 16
Va11 Mistake 1: 20,92 Va12 19,69 (<20!) Va21 12,31 Va22 11,07

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

P !( E = 0 s12 , E = 10 sonst) = 1 3 " 24 +1 3 " 10 + 1 3 " 8 = 14

Va11 Mistake 2: 19,83 (<20!) Va21 11,67 Va22 10,50

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

P !( E = 0 s12 , s11 , E = 10 sonst) = 1 2 " 10 +1 2 " 8 = 9

Va11 Investment: No investment: 20 20 Va12 Va21 9,47 Va22 8,53

Numerical example of Myers/Majluf, Dotted lines between M and M at S = 0 and S = 5

4 2 6

s21 s22 9 b = (E/P(S+a))-E S=5

s11 s12 20 a

b = (E/P(S+a))-E S=0 -10

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 Retentions Capital transfers Short-term securities Loans Trade credit Bonds Shares Other/Statistical Adjustment
(Eckbo/Masulis (1995))

UK 72,0 2,9 74,9

Germany 55,2 6,7 27,3 0 21,1 2,2 0,7 4,9 2,1 11,9 2,1 24,0 61,9

66,9 0 1,4 23,1 8,4 9,7 0,8 -10,2

66,9

42,6

2,3 21,4 2,8 0,8

0,8

4,9 -7,2

Price variations in response to stock emissions at the German market

Average 2-day-excess returns at the time of the announcement Stock excess returns of the examined companies: 0,89% 0,40% (insignificant) 1,41% 0,10% (insignificant) Following 30 days -1,04%

Kinds of stocks: Common stocks All option bonds Option bonds cum rights Option bonds ex new

(Padberg (1995), p. 235, Entrup (1995), p. 169, 181, 201)