1. Asymmetric information and Capital Structure In contrast to the agency costs problem, here the way of financing does not affect managerial actions. However, the way of financing affects what investors think about your firm and how much they will underprice/overprice the claims you sell Adverse selection problem Adverse selection problem Signaling Signaling

2. Adverse Selection Problem Assume there are two equally likely states of nature (1 – good news, 2 – bad news) The firm has liquid assets L i and tangible assets in place A i After the news has arrived the firm cosniders: (1) do nothing or (2) issue 100 of new equity to new shareholders Do Nothing Issue Equity GoodBadGoodBad LiLiLiLi5050150150 AiAiAiAi2008020080 V i (firm value) 250130350230

3. Can it be that the firm issues equity in both states? If the market thinks the firm issues 100 of equity in any state, it values the firm after investment as V = 0.5*350 + 0.5*230 = 290 The existing shareholders in the good state than get: ((V-E)/V)*V 1 = (190/290)*350 = 229.31 < 250 Hence, they will choose not to issue equity in the good state Hence, if a firm issues equity it must be in the bad state. Then the market knows V = 230. The existing shareholders than get ((V-E)/V)*V 2 = (130/230)*230 = 130. Hence, in the bad state the firm is indifferent between issuing and doing nothing We have “lemons problem”. In the good state the firm is underpriced and does not want to issue equity. Only in a bad state a firm may want to issue and the market forms believes accordingly.

4. Let’s introduce a positive NPV project Do Nothing Issue Equity GoodBadGoodBad LiLiLiLi5050150150 AiAiAiAi20080300180 NPV of new project, b i 002010 V i (firm value) 250130370240

5. If the market thinks the firm issues 100 of equity in any state, it values the firm after investment as V = 0.5*370 + 0.5*240 = 305 The existing shareholders in the good state than get: ((V-E)/V)*V 1 = (205/305)*370 = 248.7 < 250 Hence, they will still not choose not to issue equity in the good state Hence, if a firm issues equity it must be in the bad state. Then the market knows V = 240. The existing shareholders than get ((V-E)/V)*V 2 = (140/240)*240 = 140 > 130. Now in the bad state the firm strictly prefers to issue! Can it be now that the firm issues equity in both states?

6. The above result is consistent with the empirical observation: the stock price declines on the announcement of an equity issue (for US on average by 3%) Two other results that follow from the theory and are observed in practice: The stock price tends to rise prior to the announcement of an equity issue (managers wait until good news become known to the market, but does not have an incentive to wait when the news is bad) The stock price tends to rise prior to the announcement of an equity issue (managers wait until good news become known to the market, but does not have an incentive to wait when the news is bad) Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements

7. Source: Deborah Lucas and Robert McDonald, “Equity Issues and Stock Price Dynamics,” Journal of Finance 45 (1990): 1019–1043.

8. Depending on the model other types of equilibria can exist Notice: if we make NPV of the project in the good state a bit bigger, the firm will issue equity in the good state. There are two types of inefficiency that can created by asymmetric info Positive NPV projects fail to be financed (like in our model) Positive NPV projects fail to be financed (like in our model) Negative NPV projects may happen to be financed! (It happens when in the good state the project has NPV > 0, in the bad state NPV 0 and there is a pooling equilibrium) Negative NPV projects may happen to be financed! (It happens when in the good state the project has NPV > 0, in the bad state NPV 0 and there is a pooling equilibrium)

9. Implication for capital structure Pecking order theory: among the methods of financing firms that feel underpriced should start from the one which is least sensitive to information: First – retained earnings (liquid assets L i ) First – retained earnings (liquid assets L i ) Second – debt Second – debt Third – equity Third – equity Information insensitivity reduces the discount the firms incur when they sell their securities

10. Aggregate Sources of Funding for Capital Expenditures, U.S. Corporations In aggregate, firms tend to repurchase equity and issue debt. But more than 70% of capital expenditures are funded from retained earnings. Source: Federal Reserve Flow of Funds.

11. Capital Structure. Bottom line No single theory of capital structure Too many factors are in play Too many factors are in play Firms differ a lot in how they choose cap structure but there are some systematic patterns e.g. across industries or ages In each case one should understand what factors are most important

12. Capital budgeting and valuation with leverage Three methods: WACC WACC Adjusted Present Value (APV) Adjusted Present Value (APV) Flow-to-Equity (FTE) Flow-to-Equity (FTE) For this lecture we will assume that Risk of the project to evaluate = risk of the firm Risk of the project to evaluate = risk of the firm Debt/Equity remains constant Debt/Equity remains constant

13. WACC Method Note: here and below by D we will mean net debt = debt – cash. I.e. we will value the project net of its cash assets (that earn market interest rate)

14. Example Avco is considering introducing new product Will become obsolete in 4 years Will become obsolete in 4 years Annual sales: $60 mln per year Annual sales: $60 mln per year Manufacturing costs and operating expenses: $25 mln per year and $9 mln per year Manufacturing costs and operating expenses: $25 mln per year and $9 mln per year Upfront R&D and marketing expenses: $6.67 mln Upfront R&D and marketing expenses: $6.67 mln Upfront equipment expenses: $24 mln Upfront equipment expenses: $24 mln No NWC requirements No NWC requirements Tax rate = 40% Tax rate = 40%

15. Expected Free Cash Flow from Avco’s RFX Project (Spreadsheet)

16. Market risk of the project is expected to be similar to that of the company’s other lines business. Debt/equity ratio is supposed to stay the same Avco’s Current Market Value Balance Sheet ($ million) and Cost of Capital Without the RFX Project:

17. (Remember D = net debt = 300) NPV = 61.25 – 28 = $33.25 mln Notes: we use the same WACC for all periods because we assume that D/E remains constant we use the same WACC for all periods because we assume that D/E remains constant we use the WACC of the firms because we assume the project does not change D/E we use the WACC of the firms because we assume the project does not change D/E

18. Implementing a constant Debt- Equity ratio Currently Avco has D/E = 1 By undertaking the new project Avco adds new assets to the firm with initial market value V L 0 = $61.25 mln. Therefore, to maintain D/E constant Avco must add 0.5*61.25 = $30.625 mln in new debt (net debt) For this it can e.g. spend its 20 mln in cash and borrow 10.625 mln Since only 28 mln is needed to fund the projects, the rest 30.625 – 28 = 2.625 will be paid to shareholders as dividend (or share repurchase)

19. Avco’s Current Market Value Balance Sheet ($ million) with the RFX Project OK, in this way we can make sure the project doest not change D/E initially. But what happens with time?

20. We can ensure constant D/E further by properly adjusting debt each period We call the necessary for this amount of debt “debt capacity”, denote D t Here V L t – the project’s levered continuation value, i.e.

21. Continuation Value and Debt Capacity of the RFX Project over Time (Spreadsheet)

22. Adjusted Present Value Method We have to compute V U and PV(Interest Tax Shield). Let’s ignore other stuff. To compute V U we need to compute r U

23. Why is r U like this? From MM II with taxes it seems it should be: But MM II was derived (see lecture 8) under the assumption that debt is constant in perpetuity, NOT debt-equity ratio! What does it change?

24. Similarly to lecture 8: V L ≡ E + D = V U + TS V L ≡ E + D = V U + TS Thus, Dr D + Er E = V U r U + TSr TS Thus, Dr D + Er E = V U r U + TSr TS But when D/E is kept constant r TS = r U (interest tax shield becomes risky and has a similar risk to the project’s cash flows) But when D/E is kept constant r TS = r U (interest tax shield becomes risky and has a similar risk to the project’s cash flows) And, hence, we obtain And, hence, we obtain

25. Now we have to compute the interest tax shield

26. VL = VU + PV(Interest Tax Shield) = $61.25 mln NPV = 61.25 – 28 = $33.25 mln Exactly the same answer as using WACC!