Instead, the existence of senior debt constrains the amount of external funds that can be raised since the outstanding debt represents a prior claim on all assets, including new investments. This subsection surveys two papers in which reputation moderates the asset substitution problem, i. Stulz and Johnson focus on collateral, John and Nachman focus on reputation, and Bergman and Callen Forthcoming consider renegotiation with debtholders.
Berkovitch and Kim and Kim and Maksimovic Forthcoming show how debt can be used to trade off the overinvestment and underinvestment effects. Diamond and Hirshleifer and Thakor show how managers or firms have an incentive to pursue relatively safe projects out of reputational considerations. Diamond's model is concerned with a firm's reputation for choosing projects that assure debt repayment.
Both projects require the same initial investment which must be financed by debt. A firm can be of three, initially observationally equivalent types.
Corporate Finance Theory
One type has access only to the safe project, one type has access only to the risky project, and one type has access to both. Since investors cannot distinguish the firms ex ante , the initial lending rate reflects their beliefs about the projects chosen by firms on average. Returns from the safe project suffice to pay the debtholders even if the firm is believed by investors to have only the risky project , but returns from the risky project allow repayment only if the project is successful.
Because of the asset substitution problem, if the firm has a choice of projects, myopic maximization of equity value e. If the firm can convince lenders it has only the safe project, however, it will enjoy a lower lending rate. Since lenders can observe only a firm's default history, it is possible for a firm to build a reputation for having only the safe project by not defaulting. The longer the firm's history of repaying its debt, the better is its reputation, and the lower is its borrowing cost.
Therefore, older, more established firms find it optimal to choose the safe project, i. Young firms with little reputation may choose the risky project. If they survive without a default, they will eventually switch to the safe project. As a result, firms with long track records will have lower default rates and lower costs of debt than firms with brief histories.
Corporate finance - Wikipedia
Although the amount of debt is fixed in Diamond's model, it is plausible that an extension of the model would yield the result that younger firms have less debt than older ones, other things equal. Managers may also have an incentive to pursue relatively safe projects out of a concern for their reputations. Hirshleifer and Thakor consider a manager who has a choice of two projects, each with only two outcomes—success or failure. Suppose that from the point of view of the manager's reputation, however, success on the two projects is equivalent, i.
If the safer project has a higher probability of success, the manager will choose it even if the other project is better for the equityholders. This behavior of managers reduces the agency cost of debt. Thus, if managers are susceptible to such a reputation effect, the firm may be expected to have more debt than otherwise.
Hirshleifer and Thakor argue that managers of firms more likely to be takeover targets are more susceptible to the reputation effect. Such firms can be expected to have more debt, ceteris paribus. Agency models have been among the most successful in generating interesting implications. In particular, these models predict that leverage is positively associated with firm value Hirshleifer and Thakor , Harris and Raviv a , Stulz , default probability Harris and Raviv a , extent of regulation Jensen and Meckling , Stulz , free cash flow Jensen , Stulz , liquidation value Williamson , Harris and Raviv a , extent to which the firm is a takeover target Hirshleifer and Thakor , Stulz , and the importance of managerial reputation Hirshleifer and Thakor Also, leverage is expected to be negatively associated with the extent of growth opportunities Jensen and Meckling , Stulz , interest coverage, the cost of investigating firm prospects, and the probability of reorganization following default Harris and Raviv a.
Some other implications include the prediction that bonds will have covenants that attempt to restrict the extent to which equityholders can pursue risky projects that reduce the value of the debt Jensen and Meckling and that older firms with longer credit histories will tend to have lower default rates and costs of debt Diamond Finally, the result that firm value and leverage are positively related follows from the fact that these two endogenous variables move in the same direction with changes in the exogenous factors Hirshleifer and Thakor , Harris and Raviv a , Stulz Therefore, leverage increasing decreasing changes in capital structure caused by a change in one of these exogenous factors will be accompanied by stock price increases decreases.
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The introduction into economics of the explicit modeling of private information has made possible a number of approaches to explaining capital structure. In these theories, firm managers or insiders are assumed to possess private information about the characteristics of the firm's return stream or investment opportunities. In one set of approaches, choice of the firm's capital structure signals to outside investors the information of insiders.
This stream of research began with the work of Ross and Leland and Pyle In another, capital structure is designed to mitigate inefficiencies in the firm's investment decisions that are caused by the information asymmetry. This branch of the literature starts with Myers and Majluf and Myers We survey the various approaches in the following subsections.
Table of Contents
If firms are required to finance new projects by issuing equity, underpricing may be so severe that new investors capture more than the NPV of the new project, resulting in a net loss to existing shareholders. In this case the project will be rejected even if its NPV is positive.
This underinvestment can be avoided if the firm can finance the new project using a security that is not so severely undervalued by the market. Even not too risky debt will be preferred to equity. Moreover, if such debt is available, the theory implies that equity never be issued by firms in the situation of extreme information asymmetry they model.
Note also that there can be a pooling equilibrium in which all firms issue securities, because the project's NPV exceeds the worst underpricing. This equilibrium would not have the properties of the separating equilibrium mentioned in the text.
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To understand why firms may pass up positive NPV projects, suppose there are only two types of firms. Initially, the firm's type is known only to the firm's managers whose objective is to maximize the true value of the current shareholders' claim. Dybvig and Zender point out that optimal contracts with managers could completely resolve the underinvestment problem rendering capital structure irrelevant. The papers surveyed in this section thus implicitly assume that such contracts are ruled out. Outside investors believe the firm is of type H with probability p and type L with probability 1— p.
Both types of firm have access to a new project that requires an investment of I and has NPV of v I and v can be assumed to be common knowledge. The firm must decide whether to accept the project. If the project is accepted, the investment I must be financed by issuing equity to new shareholders. Consider the following candidate equilibrium.
A type H firm rejects the project and issues no equity while a type L firm accepts the project and issues equity worth I. Investors believe that issuance of equity signals that the firm is of type L. To verify that this is an equilibrium, first notice that investor beliefs are rational. Second, given these beliefs, the equity issued by type L firms is fairly priced by the market, i.
Consequently, the current shareholders of type L firms capture the NPV of v in the new project by issuing equity. They would not prefer to imitate type H firms since this would require passing up the project along with its positive NPV with no compensating gain in valuation of the existing assets, i.
Third, if a type H firm passes up the project, the payoff to current shareholders is simply H. On the other hand, if a type H firm imitates a type L firm by issuing equity, this equity will be priced by the market as if the firm were type L. The underpricing of the new equity can be so severe that current shareholders of the type H firm give up claims to the existing assets as well as the entire NPV of the new project. They are thus worse off by taking the project.
A matter of degree
Consequently, for parameters satisfying this inequality, in equilibrium, only type L firms will accept the positive NPV project. The inequality then states that underinvestment occurs if this transfer exceeds the NPV of the project. Probably the most important implication is that, upon announcement of an equity issue, the market value of the firm's existing shares will fall.
Moreover, financing via internal funds or riskless debt or any security whose value is independent of the private information will not convey information and will not result in any stock price reaction. Third, Korajczyk, et al. Therefore equity issues will tend to cluster after such releases and the stock price drop will be negatively related to the time between the release and the issue announcement. They show that firms with private information that current earnings are low will not delay projects, while firms whose current earnings are high will delay until this information becomes public.
The result is that, on average, equity is issued after a period of abnormally high returns to the firm and to the market.