A Theory of Capital Structure Relevance under Imperfect Information

Abstract

Firms raise debt and equity capital to finance a positive net present value project in perfectly competitive capital markets; firm insiders know the function generating the random firm cash flow but potential capital suppliers do not. Taking into account the incentives of insiders to misrepresent their firm type, capital suppliers attempt to design financing mixes of debt and equity that eliminate the adverse incentives of insiders and correctly price securities. Necessary conditions for a costless separating equilibrium are developed to show that the amount of debt used by a firm is monotonically related to its unobservable true value. STIGLITZ [19] AND FAMA [5] DEMONSTRATE that the Modigliani-Miller [10] capital structure irrelevance theorem holds under a fairly general set of assumptions. One of these assumptions is that investor expectations of the returns of individual firms are independent of their capital structures. This paper introduces asymmetric information into an otherwise perfect, Modigliani-Miller world and develops a signaling equilibrium in which investor expectations about individual firms do depend upon the capital structures of the firms.'In existing equilibrium models of markets with asymmetric information, such as Spence's [17] labor market, Rothschild and Stiglitz's [15] insurance market, or Leland and Pyle's [9] financial structure model, the sellers of higher quality products (higher quality labor, better insurance risks, or more valuable securities) incur some deadweight loss, since buyers are unable to distinguish quality without a signal from the seller; to prevent low quality sellers from sending a misleading signal, the signal must be costly. This paper describes a costless signaling equilibrium, in which sellers incur no deadweight losses and are as well off as they would be in a world of symmetric information. This equilibrium is not subject to the instability problems which may exist in the costly signaling equilibria.2 * University of British Columbia, Canada. 'Other models have utilized other imperfections to demonstrate capital structure relevance. For example, Rubinstein [16] and Stiglitz [18] segment the market by tastes and beliefs, respectively, to develop debt/equity relevance. Many authors have used taxes and bankruptcy costs; Kraus and Litzenberger [8] is one example. Myers [11] combines moral hazard in firms' investment decisions with corporate taxes to show capital structure relevance. Jensen and Meckling [7] and Titman [20] use monitoring/bonding and liquidation costs, respectively, to derive optimal capital structure. A recent survey is provided by Chen and Kim [4].2 A costly signaling equilibrium may be unstable if there exists some pooling offer that is profitable to the buyer and that all sellers prefer to the signaling contracts. A pooling offer is a purchase offer at a single price corresponding to the price of the average quality product in the market; thus, in a 1141

A Summary of Literature: Convertible Bond Issue Announcement Effect

“…They put forward various hypotheses and at the same time have the hypotheses tested. Heinkel R. (1982) points out that investors have the right to decide whether to design in advance to convert shares or not according to the future development condition because convertible bonds have option property in the future [26]. In this way, agency conflict between shareholders and creditors to a certain extent.…”

The use of stand alone warrants as unique capital raising instruments

“…For example, Myers and Majluf (1984) predict that new equity issues will convey negative information. Ross (1977) and Heinkel (1982) suggest that changes in leverage signal management's inside information about expected changes in future firm performance. Harris and Raviv (1990) and Stulz (1990) develop agency models where leverage is positively associated with firm value.…”

“…RUNUP is calculated as the cumulative excess return over ðÀ60; À2Þ. Ross (1977) and Heinkel's (1982) information asymmetry signalling models suggest that changes in leverage (LEVERAGE) signal management's inside information about expected changes in future firm performance. Assuming unbiased managerial expectations, the model predicts that the change in expected future performance is significantly worse for firms that issue shares than for firms that issue convertible or straight debt.…”

Debt vs. Equity and Asymmetric Information: A Review

“…As in Ross (1977), the Leland and Pyle model predicts a positive correlation between firm quality and leverage. Heinkel (1982) devises a model of debt signaling in which the information asymmetry is about both the mean and the variance of returns. The assumed (positive) relations between mean and variance drives a signaling equilibrium in which higher-value firms signal their quality with higher debt levels.…”