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BMA Ch 18, 19
LSE
3 Asymmetric Information
Signaling
Pecking Order Theory
3 Asymmetric Information
Signaling
Pecking Order Theory
2 No transaction costs
3 No taxes
4 No bankruptcy costs
Firm valuation:
Equityholder valuation:
Debtholder valuation:
Due to the conflict of interest, no one has the incentive to pick the
best project. In our example, if managers act in the interests of
shareholders, they will pick Project 2 (NPV = −32!).
The negative effects can be big
This is a real cost of financial distress
0.5
30
0.5
0 (D: 0, E: 0)
Assets 30 Debt 25
Equity 5
Total Assets 30 Total Liabilities 30
25
0.75
0 (D: 0, E: 0)
3 Asymmetric Information
Signaling
Pecking Order Theory
0.5
60
0.5 10
In the previous example, who gains and who loses if the following
cases happen?
2 Bondholder loses. The firm adds assets worth $10 and debt
worth $10. Increased debt ratio makes old bondholders more
exposed. Old bondholders loss is stockholders gain.
where:
VL : levered value of project/firm
VU : all-equity value of project/firm
PV(tax shields): value of all tax savings from debt
PV(costs of financial distress): value of all direct and indirect
costs of financial distress
A model of default:
∞
X p (1 − p)t−1 CFD pCFD
PV(CFD) = t =
(1 + rD ) rD + p
t=1
1
1
Source: Berk and DeMarzo
Jojo Paul Lecture 6: Capital Structure III 28/50
Trade-off Theory and Prices
Debt ratios have not increased since the time when corporate
income tax rates were low
3 Asymmetric Information
Signaling
Pecking Order Theory
2 No transaction costs
3 No taxes
4 No bankruptcy costs
Assumptions:
The firm does not have this cash and can only issue equity.
No taxes, transactions costs or other market imperfections.
Managers maximise the wealth of the old (current)
shareholders
Old shareholders do not purchase the new stock issue
Vfirm = 150 (Existing assets) +100 (New equity) +20 (NPV) = 270
Payoffs:
New: 37% × 270 = 100 (they break even, i.e. fair value)
Old: 63% × 270 = 170 = 150 + 20 (old shareholders capture the
NPV of the project)
Jojo Paul Lecture 6: Capital Structure III 39/50
Example: Uncertain Benchmark Case
Payoffs:
New: 46.5% × 215 = 100 (fair value)
Old: 53.5% × 215 = 115 = 100 + 15 (i.e. old shareholders
capture the expected value of the existing assets and NPV)
Also need to check that managers would not issue in State 1 under
these terms:
Old shareholders: 37.5% × 270 = 101.25 < 150 Don’t issue!
Equilibrium outcome:
If State 1: no issuance
Old shareholders worth 150
If State 2: sell 62.5% of company priced at 160.
Old shareholders worth 60
Expected wealth of old shareholders: (150 + 60)/2 = 105 < 115
(symmetric case with uncertainty)
Loss = 10 = 20 × 0.5, i.e. the NPV = 20 project in State 1
that is foregone (50% prob.)
Jojo Paul Lecture 6: Capital Structure III 45/50
Example: Conclusions
3 Asymmetric Information
Signaling
Pecking Order Theory
Pecking order:
1 Least sensitive: Retained earnings (cash), risk-free debt
2 Median: Risky debt
3 Most sensitive: Equity
2
Source: Federal Reserve Flow of Funds (in Berk & DeMarzo)
Jojo Paul Lecture 6: Capital Structure III 50/50