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Assymmetric Information

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AFIN808 CORPORATE FINANCE WEEK 8 ASYMMETRIC INFORMATION
We have covered parts of this topic before – more in the form of story‐telling than rigorous analysis. Miglio provides a more rigorous approach in three short chapters, and these are provided in ilearn. In this lecture the propositions from Miglio are provided, to demonstrate the potential complexity of this area. Three Key concepts are: asset substitution; debt overhang; and information asymmetry. In an exam you might be asked to discuss a proposition, buy you would not be Asked to reproduce a proof.

SHAREHOLDERS [2]

CREDITORS [1] Two distortions can arise from agency problems between creditors and shareholders: shareholders’ tendency to invest in very risky projects, even –ve NPV projects; tendency to under‐invest in +ve NPV projects. DEBT OVERHANG

MANAGEMENT

ASSET SUBSTITUTION

ASSET SUBSTITUTION [Jensen and Meckling (1976)] One of the most important concepts in corporate finance. When a firm takes on investments which transfer wealth from creditors to shareholders. By taking on RISKY Investments.

SHAREHOLDERS have Limited Liability: Can avoid a far greater part of the downside when an investment turns BAD. Induces shareholders to take on more risk.

CREDITORS have no insurance against being paid less than the Principal plus interest if project Fails.

Induces creditors to desire Investments with low risk.

ASSET SUBSTITUTION Proposition 18: When a project’s cash flow distribution first‐order dominates the cash flows from another project, the shareholders will choose the project with the higher NPV regardless of the level of debt. State dominates – greater than in every state. Example: company has choice between two projects, A and B. The company has debt due in one year with face value of $40,000. Coupon rate is 0%. There are three states of nature: bad, mediocre, and good –

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