B7 Asymmetric information and capital structure

Question 1

Adverse selection in financial markets

Answer 1

Idea that when buyers and sellers have different information, the average quality of assets in the market will differ from the average quality overall
Two situations can occur:
Underinvestment: good borrowers do not get financing, even though they have profitable projects
Overinvestment: also bad firms get financing, even though they are not creditworthy

Question 2

QQ: A simple model - private information about prospects

Answer 2

own funds A, investment costs I, moral hazard B, project return R, borrower is either good with true probability p or bad with true probability q and anticipated probabilities a and 1-a
Case 1: pR>I>qR (only good type is creditworthy).
investors’ prior success probability m=ap+(1-a)q. No lending if mR < I. => possible Underinvestment
Case 2: pR>qR>I (both firms creditworthy)

Question 3

Problem of adverse selection is increasing in…

Answer 3

The problem of adverse selection is increasing in…
the anticipated probability of bad type 1-a,
and the likelihood ratio (p-q)/p (rel. difference in riskiness between good and bad firms)

Question 4

Definition collateral

Answer 4

Collateral is a borrower’s pledge of specific property to a lender, to secure repayment of a loan (e.g. real estate, accounts receivable, machines)

Question 5

Collateral as screening device

Answer 5

Collateral can be seen as a costly signal of private information
It is more expensive for bad firms to pledge collateral as the probability of failure and therefore loss of the collateral, is greater than ford good firms
Cost of collateral good firm = (1-p)C; Cost of collateral bad firm = (1-q)C

Question 6

mimicking constraint intuition

Answer 6

qRb — (1-q)C ≤ qR — I
It states that it is bester for a bad-type borrower not to offer this contract, even if this reveals her type, than to mimic the good type and suffer the risk of losing the collateral. Instead they are willing to pay higher interest rates, whereas good borrowers are willing to pay a higher collateral.

Question 7

Adverse selection in SME finance

Answer 7

The problem of adverse selection is larger for SMEs for the following reasons:

(1) SME’s are opaque: young firms, short history of financial records, less disclosure requirements
(2) Lack of collateral
solution: Government takes risk via loan guarantees

Question 8

Pecking order theory and adverse selection

Answer 8

Adverse selection entails cross-subsidization from good to bad borrowers. Issuing debt minimizes the adverse-selection problem for a good borrower (debt preferable to new equity).
More generally, the good borrower would want to issue low-information-intensive claims to mitigate the adverse selection problem.

Question 9

Adverse selection: Implications for equity issuance

Answer 9

(1) stock price declines on the announcement of an equity issue
(2) stock price tends to rise prior to the announcement of an equity issue
(3) firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements

Question 10

Emprirical evidence on Trade-off theory

Answer 10

Question 11

Emprirical evidence on pecking order theory

Answer 11

Question 12

Summary asymmetric information and capital structure

Answer 12

(1) Adverse selection in financial markets:
— underinvestment / overinvestment
— collateral could mitigate the AS problem
(2) Pecking order theory:
— retained earning > debt > equity