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Lecture 2 Spring 2019.pptx
Lecture_2_Spring_2019.pptx
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Lecture 2 Spring 2019.pptx-FINA6278 LECTURE 2 – CO...
Lecture_2_Spring_2019.pptx-FINA6278 LECTURE 2 – CORPORATE LEVERAGE
Lecture 2 Spring 2019.pptx-FINA6278...
Lecture_2_Spring_2019.pptx-FINA6278 LECTURE 2 – CORPORATE LEVERAGE
Page 28
Information asymmetry
We assumed that markets and managers have the same set of
informaon.
Instead now we can assume that:
Managers have more and beer informaon about the firm than outside
investors
Both pares are aware of this informaon asymmetry
A firm can signal its high quality by issuing debt:
By issuing debt, the firm commits to make certain interest payments in the
future
Breaking this commitment will lead to financial distress and possibly
bankruptcy
Thus, firms are unlikely to commit to such a policy unless they feel confident
that they can actually meet these interest payments
Page 29
Costs of Accessing Markets
Informaon asymmetry also implies that there is a cost of accessing
external markets
Example: A firm’s assets are worth either $90 or $110
From the market’s perspecve both values are equally likely
The firm management knows the true value (either $90 or $110) of the firm
with certainty
The firm is currently all equity financed
The firm has idenfied an investment opportunity that requires $10 of
addional capital but which would create $1 of addional value
Would the firm access equity markets to invest in the new opportunity?
Page 30
Costs of Accessing Markets
Would the firm access equity markets to invest in the new
opportunity?
If the firm is actually worth $90, then yes. It has nothing to lose.
Markets think it is worth $100, so it will issue equity at overvalued
prices.
If the firm is actually worth $110, then maybe not. Markets think it
is worth $100, so it will be forced to sell shares at “too low” a
price. Some firms will decide this is not worth the cost of invesng.
The project is not taken.
Page 31
Costs of Accessing Markets
But investors know this and will respond to this logic:
If a firm issues equity, then it must be overvalued, its true value is
then $90
Undervalued firms do not issue equity and do not invest in the
project.
Same problem for debt financing. The firm worth $110 and firm
worth $90 will be charged the same interest rate. But firm
worth $110 may not be willing to pay since it knows it is higher
quality.
Page 32
Costs of Accessing Markets
But investors know this and will respond to this logic:
If a firm issues equity, then it must be overvalued, its true value is
then $90
Undervalued firms do not issue equity and do not invest in the
project.
Same problem for debt financing, but less severe.
The firm worth $110 and firm worth $90 will be charged the same
interest rate.
This may be too high of an interest rate for the beer quality firm.
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