Asymmetric Information EC Borja Larrain

Transcription

1 Asymmetric Information EC 1745 Borja Larrain

2 Today: 1. Cost of equity financing: asymmetric information. 2. Empirical implications and evidence. 3. The timing of equity issues. Readings: Chapter 18 Welch

3 In this class: Whatifthemanagerknowsmoreaboutthecompany than new shareholders? Is there a "lemons problem" in equity issues? Why firms finance most of their investment through internal funds (retained earnings)? Why do stock prices fall when a firm announces an equity issue? How often do firms issue or repurchase equity? How do equity issues vary with the business cycle?

4 1 Cost of equity financing: asymmetric information 1.1 Intuition Something is missing from the trade-off theory of capital structure: firms tend to finance investment with the most readily available funds first (retained earnings) and only afterwards they think about issuing securities. In particular, firms are usually reluctant to issue equity. Firms follow a "pecking order" to finance investment:

5 1. Internal funds. 2. Debt. 3. Equity. The reason academics give for this ranking in the sources of funds is related to asymmetric information: managers or current shareholders know more about the company than new shareholders (Myers and Majluf 1984). "Lemons problem": when you buy new equity you are afraid of being the uninformed party in the transaction. You are basically afraid of paying too much. Think about your experience when buying used cars: did you walk away with the feeling that you paid too much?

6 If investors have this fear, then they will apply a discount to equity issues. Equity is expensive (undervalued) from the point of view of the company. Debt is less "information-sensitive" than equity: think that interest/coupons are determined in advance, unlike dividends. Issuing equity should be "financing of last resort", after all other possibilities are exhausted. Issuing equity is usually taken as a bad signal about the firm: if the firm is willing to issue despite all the problems with equity, it s probably still overvalued or in really deep financial trouble.

7 Thinking about the 4 types of friction that break perfect markets and hence M&M, the friction we introduce here has to with differences of opinion/information between market participants. 1.2 Example Assume there are two types of firms: high and low value. All firms are financed 100% with equity. High value firms have assets in place worth $100, and low value firms have assets worth only $20. Current shareholders know exactly the value of the assets in place.

8 At t =0, the market does not know with certainty about the quality of assets: it attaches a probability of 10% that the firm has high-value assets and 90% that it has low-value assets. The market price is simply the probability-weighted average of firm types: P 0 = =28 At t =1, a new project requires an investment of $1 and gives $2 in cash flows. In a risk-neutral economy with 0% interest rate (i.e., no discounting), the NPV of this project is $1. Everyone in the market knows abouttheprojectanditscashflows. Both firms think about issuing equity to raise funds for the new project. Let s consider first the high-value firm: the trade-off it faces is between dilution (undervaluation in the market) and passing up a positive NPV project.

9 The decision of the high-value firm depends on the price the market pays for its shares. Let s assume initially that the market price is still the average of firm types. There is no asymmetric information with respect to the new project, so its present value is known: P pool 1 = =30 Current shareholders have to sell shares for $1 to invest in the project so they need to sell a fraction 1/30 of the firm. The fraction that is retained by the current shareholders has a true value of: µ 1 1 ( ) =

10 If this firm does not issue new equity, the current shareholders know they have assets worth $100. Therefore, why issuing? The high-value firm prefers to forgo the investment opportunity because undervaluation is too severe. The market undervalues the high-value firms because it bunches them together with the low-value firms. The high-value firm prefers not to issue equity to send a signal to the market: I m good! Can P pool 1 be an equilibrium? No, it assumes implicitly that both firms are issuing. But the issuance decision of firms sends a valuable signal to the market. After the "no-issuance" decision, the market price is: no issue P1 =100

11 Will the low-value firm be tempted to forgo the investment opportunity to look like the high value firm? No, the true value of the assets of this firm is still $20, and the new project is too good to avoid. Arewesurethelow-valuefirm is still willing to issue and invest in the project? Let s check. If the low-value firm issues equity, it separates itself from the high-value firm. Therefore, the market knows its type: P issue 1 =20+2 The dilution vs. no-issue tradeoff is: µ 1 1 (20 + 2) = 21 vs The low-value firm will always be tempted to issue because, almost by construction in this example, the market will never undervalue its assets.

12 Issuing is a bad signal. The change in price between t =0and t =1for the firm that issues equity is: P issue 1 P 0 =22 28 = 6 Not issuing, or perhaps issuing debt instead, is a good signal: no issue P1 P 0 = = +72 What situation is an equilibrium (pooling vs. separating) depends on the probabilities, the value of the new project and so on. See the problem set for a question along these lines. In this model old shareholders care about the market price only as a source of financing. It has no intrinsic valuetothem. Theyknowthetruevalueofthe assets they have and they stick to it no matter what the market thinks. Is this realistic?

13 2 Empirical implications and evidence 2.1 Pecking Order theory of capital structure Firms choose the form of financing that minimizes costs of asymmetric information: 1) internal funds, 2) debt, and 3) equity. If the firm uses internal funds it does not need to raise funds in the market. This is a theory about incremental financing decisions. Really, a theory about changes in the capital structure, not the capital structure per se.

14 This theory does not predict that firms have a target or optimal leverage ratio; just use whatever source of funds available at the time that minimizes asymmetric information costs. The pecking order theory implies that "financial slack" or "financial flexibility" is valuable to avoid issuing equity in the future. Financial slack can be in the form of retaining more earnings or saving debt-capacity for future projects.

15 218 J.R. Graham, C.R. Harvey / Journal of Financial Economics 60 (2001) 187}243 Fig. 6. Survey evidence on whether "rms have optimal or target debt}equity ratios. The survey is based on the responses of 392 CFOs.

16 Fig. 5. Survey evidence on some of the factors that a!ect the decision to issue debt. The survey is based on the responses of 392 CFOs.

17 2.2 Frequency of equity issues Accordingtothepeckingordertheory,equityissues should be financing of last resort and therefore infrequent. This is be true in terms of dollar amounts: debt and internal funds are much more important. Even in the stock market boom of the 1990s, equity issuance was only 4% of assets while debt issuance was 6%. However, firms seem to be issuing and repurchasing equity quite frequently. In the 1990s, 72% of firms issued equity, 20% repurchased equity, and only 8% did nothing. Is it really that costly to issue equity? Is asymmetric information such a large cost?

18 Sources of Funds: US Corporations Internal Debt Equity 100 % of total financing

19 Sources of Funds: International Internal Debt Equity US Japan UK Canada France

20 558 E.F. Fama, K.R. French / Journal of Financial Economics 76 (2005) Table 2 Average characteristics of all firms Each year s sample includes all non-financial, non-utility firms with the necessary CRSP and Compustat data for that year (see the appendix). We report the average ratio of the annual aggregate value of the numerator for a portfolio divided by the aggregate value of assets, in percent. Thus, leverage, L/A(t), is the sum of total liabilities in year t (Compustat item 181) divided by the sum of assets in year t (6); L/A(t 1) is L/A for the previous fiscal year, t 1; dl/a is the aggregate change in liabilities from t 1 tot divided by the sum of assets at t; da/a is the aggregate growth in assets from t 1 tot divided by the sum of year t assets; profitability, E/A, is the aggregate of the sum of income before extraordinary items (18), interest expense (15), and extraordinary income (48) if available, divided by aggregate assets; dre/a is the sum of the change in Compustat s adjusted retained earnings (36) from t 1 tot divided by aggregate assets at t; the financing deficit, Def/A, is the difference between the growth in assets and the change in retained earnings, da/a dre/a; the book measure of net equity issued, dsb/a, is the financing deficit minus the change in liabilities, Def/A dl/a; and the market-based measure of net stock issued, dsm, is the splitadjusted change in Compustat shares outstanding (25) during the fiscal year times the average of the beginning and ending split-adjusted Compustat stock prices (199). The market-to-book ratio for total assets, V/A, is the aggregate of the sum of book value of debt and the market value of equity divided by aggregate assets. Firms dsm/a dsb/a dl/a dre/a da/a V/A L/A E/A Def/A t t

21 E.F. Fama, K.R. French / Journal of Financial Economics 76 (2005) Table 3 Average percents of firms that issue and repurchase equity and average issues and repurchases as percents of total assets Each year s sample (All) includes all non-financial, non-utility firms with the necessary CRSP and Compustat data for that year (see the appendix). Firms are assigned to the Small or Big category in year t if their assets are below or above those of the median NYSE firm in t. The market-based measure of net stock issued, dsm, is the split-adjusted change in Compustat shares outstanding during the fiscal year times the average of the beginning and ending split-adjusted Compustat stock prices. Thus, net stock issuers have a positive split-adjusted growth in shares, dsm40, and net stock repurchasers have a negative growth in shares, dsmo0. Gross stock repurchases, GR, is Compustat annual item 115. Gross stock issues, GI, is netissues, dsm, plus gross repurchases. % in dsm group % with GI40 % wit h GR40 % with GI/A41% All Small Big All Small Big All Small Big All Small Big Part A: percent of firms in dsm categories that issue and repurchase All dsm groups dsmo dsm= dsm

22 2.3 Market reaction to financial policy The pecking order theory explains why we see a price drop at the announcement of equity issues. Corporate actions convey information to the market: this is perhaps the most important insight of the pecking order theory. Equity issues are accompanied by a price fall of 3% 4%. Leverage-increasing announcements (debt issues, stock repurchases) have positive effects on stock prices.

23 Stock price reaction to equity issue announcements 0.5 Cumulative Excess Return (%) Day after announcement Average cumulative excess returns from 10 days before to 10 days after announcement for 531 common stock offerings (Asquith and Mullins (1986)) 6

24 3 The timing of equity issues There may be "good" and "bad" times to issue stock. Best not to issue when asymmetric information is high, i.e., when the difference of opinion/information between insiders and potential shareholders is high. We see that aggregate equity issuance varies a lot in time: "hot" and "cold" markets. The pecking order theory suggests that "hot" markets are times of low asymmetries of information. Perhaps these are times when it is easy to credibly communicate with potential shareholders. CFOs seem to believe there are good and bad times to issue equity. However, they only talk about over or undervaluation, but not necessarily about asymmetric information as the source of these valuation differences.

25 Initial Public Offerings (IPOs) Date (YearMonth) 27

26 Seasoned Equity Offerings (SEOs) Number of SEOs Date (YearMonth) 28

27 230 J.R. Graham, C.R. Harvey / Journal of Financial Economics 60 (2001) 187}243 Fig. 7. Survey evidence on some of the factors that a!ect the decision to issue common stock. The survey is based on the responses of 392 CFOs.

28 If markets are perfect and efficient: prices fluctuate to reflect new information. All assets are fairly priced at any point in time. If markets are not perfect and inefficient: prices can deviate from the "true" value. What if managers can spot those deviations and act as "arbitrageurs" (i.e., issue equity when stocks are overvalued and repurchase when stocks are undervalued)? Are managers so smart and investors so stupid? Big debate: efficient market-ers vs. behavioral-ists. The debate is still open, although the empirical facts are clear: Market returns after periods of active issuance are low.

29 Stocks of firms that issue tend to underperform when compared to "similar" firms (i.e., firms with similar risk profiles). Capital structure implication: the capital structure would be the accumulation of past attempts to "time" the market. A firm that raises funds in "hot" markets will have disproportionately low leverage since equity is cheap in those times. The opposite goes for firms that raise funds in "cold" markets.

30 2228 The Journal of Finance Figure 2. Mean equity returns by prior-year equity share in new issues, Mean annual real returns on the CRSP value-weighted ~light! and equal-weighted ~solid! indexes by quartile of the prior-year share of equity issues in total equity and debt issues. Real returns are created using the Consumer Price Index from Ibbotson Associates ~1998!.

31 The Equity Share in New Issues 2229 PANEL A. Mean returns on the VW CRSP (light) and EW (solid) CRSP indexes around low equity share years. PANEL B. Mean returns on the VW CRSP (light) and EW (solid) CRSP indexes around high equity share years. Figure 3. Mean past and future equity returns by equity share in new issues, Figure 3A plots mean past and future real annual returns on the CRSP value-weighted ~light! and equal-weighted ~solid! indexes for below-median equity share years. Figure 3B plots mean returns around above-median equity share years. Real returns are created using the Consumer Price Index from Ibbotson Associates ~1998!.