Free Essay

Capital Structure and Information Asymmetry

In: Business and Management

Submitted By thokzin87
Words 3507
Pages 15
This paper will discuss the choice of capital structure in markets where there is information asymmetry. Particular reference is made to how debt is used as a signalling tool along with a discussion on debt maturity structure. The pecking order theory is examined. Finally this paper reveals empirical evidence of capital structure.
Arnold Musadziruma 210525268 Clint Kruger 209541568 Kemsley Grantham 209538112

i
“Seminar 4- Capital structure and information asymmetry (2013)”

Abstract
This study is going to discuss capital structure choices of companies in an environment of information asymmetry. Firstly we discuss information asymmetry and how firms attempt to avoid a pooling equilibrium by signalling the quality of the firm. Quality can be signalled through the use of debt. The use of long term debt is a sign that a firm can make the payment obligations of the long term debt which is shown to signal good quality. The pecking order theory makes use of a hierarchy of financing sources and indicates internally generated funds should be used first. Following this, short term debt should be used before long term debt because of the risk and costs involved. Due to the costs involved in issuing equity in an environment of information asymmetry, firms should make use of equity as a last resort. The maturity structure of debt should also match the maturities of those firms’ assets to reduce costs. Empirical evidence suggests there is no common result for which theory is followed in practice; however it is shown that small firms who are high growth firms tend to follow a pecking order and larger firms follow a trade-off model. Due to the clear complexity involved in capital structure decisions, it is advised that a company sets out its objectives before choosing a model to follow.

ii
“Seminar 4- Capital structure and information asymmetry (2013)”

Table of Contents
1. 2. 3. 4. INTRODUCTION .............................................................................................................. 1 DEVELOPMENT OF CAPITAL STRUCTURE THEORY ............................................. 2 INFORMATION ASYMMETRY AND POOLING EQUILIBRIUM .............................. 3 DEBT SIGNALLING......................................................................................................... 5 4.1 How management can signal firm quality using debt ...................................................... 5 4.1.1 Uncertainty and signalling ...................................................................................... 7 4.1.2 Managerial Incentive signalling Equilibrium ................................................... 8 5. DEBT MATURITY STRUCTURE ................................................................................. 10 5.1 Asymmetric information relating to default premia....................................................... 12 5.2 Empirical results on debt maturity structure .................................................................. 13 6. THE PECKING ORDER THEORY (POT) ..................................................................... 14 6.1 Pecking Order Theory versus Static trade-off theory..................................................... 17 6.2 Implications of the Pecking Order Theory ................................................................ 20 6.2.1 Empirical Evidence ............................................................................................. 20 6.3 Implications for firms following the Pecking Order ..................................................... 22 7. 8. CAPITAL STRUCTURE IN PRACTICE ....................................................................... 23 CONCLUSION ................................................................................................................ 29

BIBLIOGRAPHY .................................................................................................................... 31

iii
“Seminar 4- Capital structure and information asymmetry (2013)”

1. INTRODUCTION
Until recently, the debate around capital structure has mainly been a theoretical one, with the relevance or irrelevance of financing decisions solely dependent upon the willingness to accept the existence of substantial market imperfections by the modeller, (see: DeAngelo and Masulis, 1980: 2, Titman, 1984: 25, Fama, 1980: 5, Smith and Warner, 1979: 22) for different perspectives on the relevance of these market imperfections. There has been a considerable amount of empirical evidence over the years as summarized by Smith (1986: 21), which now strongly indicates that changes in the capital structure of a firm can indeed affect the overall value of a firm. There has been a paradigm shift thus far, that has seen the focus of the debate shifting from whether capital structure decisions matter to why they actually matter (Pinegar and Wilbricht, 1989: 83). The fact that markets are not efficient and perfect makes the optimal capital structure decision even more intriguing, and the existence of information asymmetry between companies and investors also create a set of problems for identifying an optimal structure. In a market faced with information asymmetry, investors solely rely on signals from firms to come up with conclusions as to whether the decisions made reflect good news or bad news about the firm itself. One way a firm can attempt to signal its quality is through the use of debt where issuing long term debt can be seen as a signal that the firm has sufficient future expected cash flows to cover its interest obligations. Short term debt, on the other hand can be regarded as a bad quality signal as investors are led to assume that long term debt obligations cannot be met in the future. In addition, the maturity structure of debt can be regarded as very important, not only in portraying good information to outside investors, but also in managing the use of funds and costs associated with a particular set of funds. In order to determine the amount of debt used and the maturity of debt, one could follow the pecking order theory. The pecking order theory of capital structure thrives on the realm of information asymmetry. It suggests the use of less information sensitive sources of funds first such as internally generated funds followed by debt then other hybrid sources. This paper will be structured as follows; in Section 2, the development of capital structure theory is examined and will be followed by a discussion on information asymmetry and the pooling equilibrium in Section 3, which considers how a firm can use debt to signal good news (or quality) to the market in order to avoid the pooling equilibrium.

1
“Seminar 4- Capital structure and information asymmetry (2013)”

In Section 4 various forms of debt signalling are discussed, followed by the prospect of signalling using the maturity structure of debt in section 5. Section 6 will discuss the Peckingorder theory (POT) of capital structure, including the implications and predictions of the theory. Section 7 will subsequently follow thereafter and will highlight some of the empirical evidence in support of capital structure in the real world. Section 8 then conclude the paper.

2. DEVELOPMENT OF CAPITAL STRUCTURE THEORY
It would be unwitting for anyone to start any discussion on capital structure theory in finance without mentioning the “two founding fathers”, Franco Modigliani and Merton Miller, who in 1958 and 1963 published two articles on corporate structure that laid a firm foundation for other subsequent models. They provided ten main assumptions that were later used as a basis to formulate new models. Although most of these assumptions were considered to be unrealistic, one cannot deny that they instigated debates and research in the realm of corporate structure theories that eventually led to the formulation of new models (Copeland, Weston and Shastri, 2005: 595). The central results of modern corporate finance, based on the Modigliani-Miller irrelevancy propositions, have been summarized nicely in the following quotations: “….. the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate pk appropriate to its class” (Modigliani and Miller, 1958); And “….. the current valuation of any firms is unaffected by differences in dividend payments in any future period and thus….dividend policy is irrelevant for the determination of market prices, given investment policy” (Miller and Modigliani, 1961). (Ross, 1977) According to Frank and Goyal (200: 6), the pecking order and static trade-off, theories which will be discussed in detail in later sections, were derived from these articles by M&M.

2
“Seminar 4- Capital structure and information asymmetry (2013)”

The main focus of the M & M 1963 paper was to test the effects of taxes on the capital structure of a firm. They proposed that firms should be fully leveraged (100% debt) due to tax shields associated with interest payments that will result in savings for the firm. The assumption behind this was a constant cost of debt regardless of the amount of debt taken by the firm. Increasing debt, however, leads to other costs such as financial distress and bankruptcy costs; hence this capital structure is not optimal. As Kraus and Litzenburger (1973: 911) put it, the optimal debt to equity ratio may be seen as a trade-off between the tax savings that accrue from interest payments and increased financial distress and bankruptcy costs. Considering these costs means the capital structure should be at a point where the marginal benefit of taking on extra debt is equal to the cost associated with it. This, in essence, describes the static trade-off theory as proposed by Myers (1984: 576). Another assumption from the M & M model was that of perfect capital markets which, in essence, meant that there is no information asymmetry in the markets and that signalling does not exist. Markets are, however, not perfect and information asymmetry does exist and affects a firm‟s choice of capital structure. Arkelof (1970), one of the early pioneers of this topic, mentioned in his article that when information asymmetry is present, it results in the issue of adverse selection. Later proponents such as Ross (1977), who developed the incentive signalling approach; Myers and Majluf (1984), who developed the pecking order theory, and Flannery (1986) who developed the maturity signalling model, all mentioned information asymmetry in their articles and revealed how it affected the choice of capital structure of the firm.

3. INFORMATION ASYMMETRY AND POOLING EQUILIBRIUM
Information asymmetry occurs when managers possess additional inside information about the firm not known by the other parties (investors/shareholders and/or the general market) (Harris and Raviv, 1991: 306). Managers and other market participants are assumed to possess the same market wide information about a firm or, in other words, non-firm specific information thus both bear market wide uncertainty (Dierkins, 1991: 182-183). Managers know more about the firm because they get first-hand private information about the firm not known by the market.

3
“Seminar 4- Capital structure and information asymmetry (2013)”

This information will, however, eventually be conveyed to the public either through the passage of time or via some information-releasing event such as earnings announcements or equity issue announcements (Dierkins, 1991: 183). As Akelorf (1970) asserted in his paper, the presence of information asymmetry results in adverse selection. In his analogy, he used a hypothetical example of the market for automobiles where there are four categories of cars (new cars, used cars, good cars and bad cars) which he referred to as “lemons” in the American context. When people buy the cars, they do so without knowing that it is a good car or a lemon. Assuming that q is the proportion or probability of getting a good car and (1-q) a lemon, individuals know that with probability q it will be a good car and (1-q) that it is a bad car. The buyer can only fully know the condition of the car after owning it for a considerable length of time. By virtue of these differences in estimates, that is, when one buys a car and when they have had it for some time, an asymmetry in available information develops for sellers will have more knowledge of the quality of the cars than the buyers (Akelorf, 1970; 489). If the same prices are charged for both good cars and bad cars, it would be difficult for the buyer to ascertain the quality of the car without “inside information” (Akelorf, 1970; 489). As a result, there will be an increased incentive for sellers to sell bad cars. This will eventually lead to a drop in the expected average value of cars on the market as bad cars drive out good cars. To prevent low quality sellers presenting a misleading signal, signalling needs to be costly (Heinkel, 1982). The equilibrium may be unbalanced if there is a pooling offer ( which is a purchase offer at a single price that relates to the price of the average quality of the product in the market) that offers profits to the buyers and all sellers prefer signalling contracts (Heinkel, 1982). The pooling equilibrium refers to high quality sellers receiving low quality price and low quality sellers receiving high quality price. The pooling equilibrium will be preferred if the cost of pooling is less than that of the cost of signalling true quality (Heinkel, 1982). This same analogy as in Akelorf‟s (1970) example can be applied to the “real world” when firms sell equity on the market. If investors cannot ascertain the true value of the firm due to lack of certain inside information only known to management, then the investors will be inclined to pay a particular price for the firm. As a result, the incentive to sell equity on the market will be more appealing to the “bad” firms as opposed to the “good” ones, which will eventually result in overall firm values falling (Akelorf, 1970: 490).

4
“Seminar 4- Capital structure and information asymmetry (2013)”

Flannery (1986: 21) postulated that if investors are unable to distinguish between good quality and bad quality firms this results in a pooling equilibrium outsiders cannot differentiate the quality of the firms. If information asymmetry exists, the manager possessing the inside information can convey this information by way of signalling. If certain information, for example, results in a positive effect on the firm, it would be rational for a manager to disclose it. As a result, it would be necessary for managers to find strategies that signal the quality and good news of their firm to outsiders in such a way that it differentiates their firms from others. In the sections to follow, we are going to explain how the use of debt can signal a firm‟s value in the market so as to avoid this problem of pooling equilibrium.

4. DEBT SIGNALLING
Debt signalling plays a crucial role in signalling the quality of a firm in the presence of asymmetric information between manager and investors. Such signals, for all intense and purpose, can be seen as a firm‟s choice of capital structure (Heinkel, 1982: 1142). These signals are considered to be of no welfare cost to the firm, however, since, as proposed by Modigliani and Miller (1958), the choice of capital structure of a firm is irrelevant. By taking on debt, a firm will be signaling its ability to meet its future contractual interest obligations to the market which is taken as evidence indicating sufficient future cash flows. On the flip side, decreasing the amount of debt could be taken as a signal that the firm is unable to make payments and is not at an optimal position (Heinkel, 1982). Ross (1977) postulated that values of firms increase with leverage as leverage increases positively contribute to firm value. Although debt capacity depends on the value of the firm and the ability to pay, above average performing firms will be able to borrow more compared to poor performing ones (Myers, 2001).

4.1 How management can signal firm quality using debt
Modigliani and Miller‟s (1958) debt irrelevancy theorem was hinged on the assumption that markets were perfect and all participants were aware of all the information available, thus the choice of capital structure was not important. Markets are, however, imperfect and when dealing with imperfect information, the Modigliani and Miller theory may not hold in practice as capital structure and firm value are linked (Heinkel, 1982).

5
“Seminar 4- Capital structure and information asymmetry (2013)”

Due to the presence of information asymmetry, the choice of incentive packages for managers and financial structures, signal information to the market which may alter the perceived value of the firm (Ross, 1977). In his paper, Ross (1977) developed the incentive-signalling equilibrium which separated firms where managers were confident of better prospects from those firms where the management was not. He used a basic example in which he illustrated the relationship between management incentives and signalling and how this relationship was portrayed in the financial market. In this example the following assumptions were made:  Financial markets are competitive and complete and there are no operational costs or tax effects, therefore the firm has no monopoly power and demand is infinitely elastic at quoted prices;  There is unbiased pricing within the market and this assumption is made to make the model less complex (Ross, 1977).

This example uses the basic concept that there are only two firms, Firm A and Firm B at time 0, where the total return (value) of firm A is denoted as „a‟ and that of firm B as „b‟. It is given that a>b and this simply implies that firm A earns a higher return and is of better quality than firm B (Ross, 1977). If uncertainty is not present in the market and investors can recognize both firms A and B, their respective values at time 0 will be as follows: V0A = a 1+r and V0B = b 1+r Where „r‟ is the sure rate of interest. As clearly shown in the equations, the value of the firm is unaffected by the mode of finance chosen by the firm. < V0A

6
“Seminar 4- Capital structure and information asymmetry (2013)”

As portrayed by Ross (1977: 26) in his example, firm A has the following characteristics: It is financed by debt (D) with a face value of (F) and an equity value (E), where the debt has the senior claim to the returns of the firm with a minimum value of {F, a} at t=1 and the equity will subsequently claim the residual {a – F, 0}. The respective amounts at t=0 will thus be:

Equity = max {a – F, 0} 1+r

and Debt = min {a, F} 1+r therefore, E+D= a 1+r = V0A ,

In such a simple world, the M & M theory will just be a restatement of Fisher‟s theorem (Ross, 1977).

4.1.1 Uncertainty and signalling
If it so happens that investors cannot distinguish A firms from B firms, we use q to denote the proportion of A firms, and (1-q) to denote B firms. We also assume all investors act as though any of these firms has a q chance of being an A firm (Ross, 1977). Given the above information at time zero, firms will have a q chance of being A firms and a (1-q) chance of being type B firms. This means all firms will have the same value as shown in the following equations:

7
“Seminar 4- Capital structure and information asymmetry (2013)”

( ( )

)

with

This result follows the M & M proposition that capital structure choice does not affect firm value. It will be a waste of resources for firm A to signal to the market that they are type A rather than type B. The difficulty stems from the fact that B firms may falsely provide the same signal, thus leading to an equilibrium where it is difficult to differentiate the firms as they all look the same (Ross, 1977). To explain this in a different context, suppose an A firm were to propose a certain action, (perhaps a financial package), as a signal of their quality ( )

to investors. Then, by virtue of initial information symmetry, Firm B will also follow policies of thus will also end up realizing the initial value of ( ( ) ( (Ross, 1977). ) policy, and refinance it with activity ) leading to an equilibrium of

Using the same logic, if firm B were to adopt a , a financer will gain riskless capital gains of

therefore a financer may buy Firm B and refinance it at a value of Firm A(Ross, 1977).

4.1.2 Managerial Incentive signalling Equilibrium
There is one way in which this “constraint” that binds the value of the both A and B firms can be broken and it is to presume an important role for managers as they are assumed to possess special information about a firm‟s type or quality not known by investors. Without normal investors knowing the quality of the firm, the capital market cannot arrive at correct prices for debt and equity securities and this creates incentives for misrepresentation for the insiders (Heinkel, 1982). In this model, the following assumptions have been noted:   Insiders (managers) are classified as possessors of inside information; Insiders are compensated by a known incentive schedule (Ross, 1977).

8
“Seminar 4- Capital structure and information asymmetry (2013)”

It is assumed that management is compensated in the following way:

Where M is the incentive,

the fixed non-negative weights,

is the

value of the firm at t=0 and t=1 respectively, L the penalty assessed on an insider if there is bankruptcy at t=1 and F denotes the face value of debt. It is also assumed that managers want to maximise their incentives at time 0 by setting a level of debt financing, F, at that time so as to maximise M (Ross, 1977). The above formula can be used to establish the signalling equilibrium, where Firm A issues more debt than Firm B. The market is able to read this, determine the type of firm, and price it accordingly. Taking when:   F> F< the market will assume that this is a type A firm; the market will assume that this is a type B firm. be the significant level of financing, with b<

Similar Documents

Premium Essay

Investment Banking and the Capital Acquisition Process

...Investment Banking and the Capital Acquisition Process Smith (1986) 1. Introduction This paper reviews the various methods firms use to raise capital and the effect these methods have on security prices. Firms can raise external capital by selling several securities which they market in different ways. In terms of the theory of corporate finance, capital markets play a vital role in a firm’s investment policies. Therefore, it is critical to have an understanding of the various contractual procedures in the process of raising capital. To provide us with this understanding, this paper will look at the theory and evidence related to stock price reactions around announcements of differing security offerings, the contractual arrangements associated with the marketing of corporate securities and incentives for under-pricing in initial public equity offerings. 2. On the corporation’s choice of security to offer When contemplating the type of security to issue, the corporation must consider the reaction of the market to its announcement. Four generalisations are made when looking at the two-day common stock price reactions to the announcement of industrial and utility firms raising capital with various securities – * average abnormal returns are non-positive; * abnormal returns around the time of the announcements of common stock sales are negative and larger in absolute value than those observed with preferred stock or debt; * abnormal......

Words: 3055 - Pages: 13

Premium Essay

Mr Zheng

...Accounting Horizons Vol. 27, No. 2 2013 pp. 301–318 American Accounting Association DOI: 10.2308/acch-50434 Capital Structure, Earnings Management, and Sarbanes-Oxley: Evidence from Canadian and U.S. Firms Kelly E. Carter SYNOPSIS: I examine Sarbanes-Oxley’s (SOX) effect on capital structure. I find that SOX is associated with higher long-term debt ratios, as firms listed in the U.S. raise their long-term debt ratios by 2 to 3 percentage points. This finding is consistent with the idea that, although the reduction in information asymmetry associated with SOX could prompt managers to increase equity financing, debt is still safer and less costly than equity in the SOX era. Further analysis shows that the increase in debt occurs in the two quarters prior to SOX, suggesting that firms anticipate a higher cost of debt after SOX and acquire debt while it is relatively cheap. Also, firms that heavily (lightly) manage earnings prior to SOX use less (more) debt after SOX. This result is consistent with the view that firms that aggressively manage earnings before SOX reveal intrinsically weaker earnings after SOX, casting doubt on those firms’ ability to repay debt and relegating those firms to issue equity for financing purposes. Keywords: capital structure; earnings management; debt ratio; Sarbanes-Oxley. JEL Classifications: G32; G38. Data Availability: Data available upon request. Kelly E. Carter is an Assistant Professor at Morgan State......

Words: 10135 - Pages: 41

Premium Essay

Fnce

...• McConomy • This is a summer session class = quick • This is a 3rd year class = challenging – Quick + challenging = be organized • Do the assigned homework (min. 1:1) • Read the chapter beforehand • Come to class CHAPTER 1 The Canadian Financial Reporting Environment • Exams will have – Multiple choice & matching questions – Short answer questions – Problems – mini cases Prepared by: Dragan Stojanovic, CA 5 Copyright © John Wiley & Sons Canada, Ltd. As edited by Jeff Kent, CPA,CA M.B.A. The Canadian Financial Reporting Environment CHAPTER 1 The Canadian Financial Reporting Environment Financial Statements and Financial Reporting •Accounting and capital allocation •Stakeholders •Objective of financial reporting •Information asymmetry After studying this chapter, you should be able to: • Explain how accounting makes it possible to use scarce resources more efficiently. • Explain the meaning of “stakeholder” and...

Words: 2123 - Pages: 9

Premium Essay

Determinants of Capital Market

...DETERMINANTS OF CAPITAL STRUCTURE Introduction Modern theory of capital structure instigated with the seminal paper of Modigliani and Miller [1]. In brief, the MM theory states that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent from its corporate financing decisions. In fact, the MM theory provided conditions under which a firm’s financial decisions do not affect the value of the firm. The fundamental conditions under which a firm’s leverage becomes irrelevant to its market value, hence the MM proposition hold includes: * No taxation * No transaction costs exist * No default risk * Perfect and frictionless markets * Firms and investors can borrow at the same interest rate The MM theorem might seem extraneous but it provides cornerstone for corporate finance. However, the classic question “How do firms choose their capital structure?” remain unanswered. In finance, the term ‘capital structure’ refers to the technique followed by corporations to  finance its assets through combination of equity, debt, or hybrid securities [2]. In simple terms, a firm's capital structure is the symphony of its liabilities. For example, a firm that possesses $40 billion in equity and $60 billion in debt is said to be 40% equity-financed and 60% debt-financed. The firm's ratio of debt to equity that is 60% is referred to as the ‘firm's leverage’. Leverage and Gearing are two terms that are often......

Words: 1172 - Pages: 5

Premium Essay

Investment, Financial Factors, and Cash Row

...This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Asymmetric Information, Corporate Finance, and Investment Volume Author/Editor: R. Glenn Hubbard, editor Volume Publisher: University of Chicago Press, 1990 Volume ISBN: 0-226-35585-3 Volume URL: http://www.nber.org/books/glen90-1 Conference Date: May 5, 1989 Publication Date: January 1990 Chapter Title: Investment, Financial Factors, and Cash Flow: Evidence from U.K. Panel Data Chapter Author: Michael Devereux, Fabio Schiantarelli Chapter URL: http://www.nber.org/chapters/c11476 Chapter pages in book: (p. 279 - 306) 11 Investment, Financial Factors, and Cash Row: Evidence from U.K. Panel Data Michael Devereux and Fabio Schiantarelli 11.1 Introduction Most empirical models of company investment rely on the assumption of perfect capital markets. One implication of this assumption is that, in a world without taxes, firms are indifferent to funding their investment programs from internal or external funds. However, there is a rapidly growing body of literature examining the possible existence of imperfections in capital markets and their effects on firms' financial and real decisions. In this paper we provide some econometric evidence on the impact of financial factors like cash flow, debt, and stock measures of liquidity on the investment decisions of U.K. firms. These variables are introduced via an extension of the Q model of investment, which...

Words: 5150 - Pages: 21

Premium Essay

Change Management

...1.Capital structure A capital structure refers to the way a corporation finances its assets through the mix of equity, debt or hybrid securities. The optimal capital structure is the one in which, the market value of the firm is maximized when its cost of capital is minimized. The firm should adopt the EPS- EBIT approach to the capital structure. This approach involves selecting the capital structure that maximizes EPS (Earnings per share) over the expected range of EBIT (Earnings before interest and tax). In this approach, the main emphasis is laid upon the owner’s return that is the earning’s per share. A big disadvantage of this approach is the fact that the earnings are only one of the determinants of shareholder wealth maximization. This method also ignores the impact of risk. Another shortcoming is that it doesn’t maximize the shareholder’s wealth because it fails to consider the risk. 2. Modigliani Miller (MM) Proposition 1 The Modigliani Miller (MM) Proposition 1: The proposition indicates that a change in the business capital structure does not necessarily change the total value of the business. In other words, a business can make a choice to finance its operations either by debt or by distribution of shares. The value of a firm is independent of the capital structure of the firm under certain assumptions. The assumptions are as under- The capital structure does not matter if the investment opportunities are given and there are......

Words: 1348 - Pages: 6

Premium Essay

Lelep

...1. Tutorial #1 2. Describe the difference between a financial asset and a tangible asset. A financial asset is an intangible asset whose value is derived from a contractual claim, such as bank deposits, bonds, and stocks. Financial assets are usually more liquid than other tangible assets, such as commodities or real estate, and may be traded on financial markets. In contrast, a tangible asset is an asset that has a physical form. Tangible assets include both fixed assets, such as machinery, buildings and land, and current assets, such as inventory. 3. Describe the two principle roles of financial assets. The principal economic function of financial assets are: (1) to transfer funds from persons who have surplus funds to those who need funds to invest in tangible assets( e.g. mortgage funds lending to homebuyers); (2) transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds (seekers of funds ask others to share the risks in their undertakings). 4. a. Explain the three factors that have led to the globalization of financial markets. Globalization has led to an expansion and integration of global financial markets. Prior to the 1980’s, the US financial market was the largest in the world but with the advent of new technologies and globalization, many markets have emerged and indeed the majority of them have been integrated to form a......

Words: 3412 - Pages: 14

Premium Essay

Pecking Order

...Market-Timing Theories of Capital Structure: a Review Anton Miglo University of Bridgeport 2010 Online at http://mpra.ub.uni-muenchen.de/46691/ MPRA Paper No. 46691, posted 6. May 2013 19:07 UTC The Pecking Order, Trade-off, Signaling, and Market-Timing Theories of Capital Structure: a Review Anton Miglo Associate professor, University of Bridgeport, School of Business, Bridgeport, CT 06604, phone (203) 576-4366, email: amiglo@bridgeport.edu. This version: 2013 Initial version: 2010 Abstract. This paper surveys 4 major capital structure theories: trade-off, pecking order, signaling and market timing. For each theory, a basic model and its major implications are presented. These implications are compared to the available evidence. This is followed by an overview of pros and cons for each theory. A discussion of major recent papers and suggestions for future research are provided. Introduction The modern theory of capital structure began with and the famous proposition of Modigliani Miller (1958) that described the conditions of capital structure irrelevance. Since then, been changing these conditions to explain factors driving capital many economists have structure decisions. Harris and Raviv (1991) synthesized major theoretical literature in the field, related these to the known empirical evidence, and suggested promising avenues for future research. They argued that asymmetric information theories of capital structure are less promising than......

Words: 8184 - Pages: 33

Premium Essay

Healthcare

...of voluntary IFRS adoption by publicly traded German firms during the period 19982004, we find that size, international exposure, dispersion of ownership, and recent IPOs are important drivers. Second, using the results from this determinant model to construct propensity score-matched samples of IFRS and German-GAAP (HGB) firms, we document significant differences in terms of earnings quality: IFRS firms have more persistent, less predictable and more conditionally conservative earnings. Third, analyzing information asymmetry differences between IFRS and HGB firms, we show that IFRS adopters experience a decline in bid-ask spread of 70 base points and an average of 17 more days with price changes per year. On the other hand, IFRS adopter’s stock prices seem to be more volatile. In the light of some important limitations of our study, we discuss IFRS-related research opportunities in post-2005 Europe. Keywords: IFRS, earnings quality, earnings attributes, information asymmetry, standard setting, IAS Regulation, Europe, propensity-score matching,...

Words: 11298 - Pages: 46

Premium Essay

Marketing

...1 HOTEL OWNER / OPERATOR STRUCTURES: IMPLICATIONS FOR CAPITAL BUDGETING PROCESS Chris GUILDING Service Industry Research Centre, and School of Accounting and Finance Griffith University – Gold Coast Campus Queensland AUSTRALIA C.Guilding@griffith.edu.au Tel: (07) 5552 8790 Fax: (07) 5552 8068 I am grateful for funding support for this study provided by the Australian Cooperative Research Centre for Sustainable Tourism. I would also like to acknowledge the helpful comments and suggestions provided by two anonymous referees. 23 HOTEL OWNER / OPERATOR STRUCTURES: IMPLICATIONS FOR CAPITAL BUDGETING PROCESS ABSTRACT The findings of a field study concerned with appraising capital budgeting process implications arising from different owner / operator structures employed in the hotel industry are reported. Dimensions of conflict that can arise between hotel operators and owners are examined. Consistent with expectations motivated by agency theory, data collected suggest that capital budgeting systems in hotels operating under a divorced owner / operator structure exhibit more formalisation and a greater propensity for investment proposal cash forecast biasing. These findings suggest a degree of dysfunctionalism associated with the divorced / owner operator structure widely adopted in the hotel industry. Key words: Hotel, Capital Budgeting, Ownership structure, Agency theory.4 ...

Words: 12681 - Pages: 51

Premium Essay

Team Concept

...decisions, the necessity to ensure financial statements are easily conversed is imperative. To achieve maximum decision usefulness of financial statement information, corporations should follow a standardized reporting system that allows for comparability, reduces information asymmetry between themselves and their investors and follows a rule-based methodology. The information presented on the financial statements is only useful if it can enable investors to make more informed investment decisions. Fischer (1989) states that comparability is a fundamental characteristic of financial reporting and “without comparability financial reporting lacks usefulness in decision making” (page 9). In addition, Fischer (1989) also points out that to achieve comparability of financial reporting, accounting choice should be concentrated on one specific method or at most, a few limited methods (page 9). Beke (2010) argues that without standardized reporting, cross-border comparability would decrease which may result in distorting cross-border portfolio and direct investment (page 1). Beke (2010) is in favour of the financial reporting standardization as empirical research evidence shows that uniform standards “will increase market liquidity, decrease transaction costs for investors, lower cost of capital, and facilitate international capital formation and flow” (page 5). Beke (2010) states that the greater comparability in financial results, the more analysts would follow trends, which......

Words: 1233 - Pages: 5

Premium Essay

The Implications of Risk Management Information Systems for the Organization of Financial Firms

...Risk Management Information Systems for the Organization of Financial Firms Michael S. Gibson* Federal Reserve Board Abstract Financial dealer firms have invested heavily in recent years to develop information systems for risk measurement. I take it as given that technological progress is likely to continue at a rapid pace, making it less expensive for financial firms to assemble risk information. I look beyond questions of risk measurement methodology to investigate the implications of risk management information systems. By examining several theoretical models of the firm in the presence of asymmetric information, I explore how a financial firm’s capital budgeting, incentive compensation, capital structure, and risk management activities are likely to change as it becomes less costly to assemble risk information. I also explore the likely effects of the falling cost of assembling risk information on a financial firm’s organizational structure. Two common themes emerge: centralization within the firm and increased disclosure of risk information outside the firm are both likely to increase. 1 Introduction Financial dealer firms have invested heavily in recent years to develop information systems for risk measurement and management.1 These systems gather data on a firm’s risk positions and compute statistical measurements, such as Value-atRisk, to assess the magnitude of the risks faced by the firm. Increasingly, the uses of these information systems......

Words: 4467 - Pages: 18

Premium Essay

A Review of Corporate Financial Policy in Emerging Markets: the Role of Financial Policy

...Definition of Key Terms Introduction Research Problems Methodology Key Findings Study Gaps For Future Research Research Questions Literature Review Conclusion and Remarks Definition of Key Terms  Financial markets: This is a market where financial instruments are traded.  Emerging markets: An emerging market economy (EME) is defined as an economy with low to middle per capita income  Financial policy: Criteria describing a corporation's choices regarding its debt/equity mix, currencies of denomination, maturity structure, method of financing investment projects, and hedging decisions with a goal of maximizing the value of the firm to some set of stockholders. Definition of Key Terms  Capitalization: The total dollar market value of all of a company's outstanding shares.  Capital structure: Refers to the way a corporation finances its assets through equity and long-term debt.  Financial structure: The structure of a company's sources of financing, including shareholders' equity, long- and short-term debt, and accounts payable. Research Problem  The financial markets in emerging markets have undergone considerable growth in recent times, mainly as a result of the trade and financial liberalization policies adopted by these countries over the past decade (Agarwal and Mohtadi, 2004). This development has expanded the financing options available to firms, but raises the important policy question of how financial market development......

Words: 1333 - Pages: 6

Premium Essay

Financial Intermediation

...and management function 3 Why are financial intermediaries important? 3 THEORIES OF FINCANCIAL INTERMEDIATION 3 Informational Asymmetries 3 Transaction Costs Theory 4 Regulation 4 HISTORICAL DEVELOPMENT 5 Origin of Financial Intermediation 5 EVOLUTION OF FINANCIAL INTERMEDIATION 6 THE FUTURE OF FINANCIAL INTERMEDIATION 7 TRENDS IN FUTURE FINANCIAL INTERMEDIATION 8 Regulation (Deregulation) 8 Revised regulatory framework 8 Revised reporting standards and accounting 8 International Monitoring and Oversight 9 Effects on Insurance 9 Technology 9 New financial innovations 9 Globalization 9 Presence 9 Scale 10 Increased Government involvement 10 IMPLICATIONS 11 CONCLUSION 11 BIBLIOGRAPHY 12 FINANCIAL INTERMEDIATION INTRODUCTION Financial Intermediation is a crucial and pervasive feature of all world economies. But as Franklin Allen (2001) observed in his AFA presidential Address, there is a widespread view that financial intermediaries can be ignored because they have no real effect. But this cannot be true, in my opinion, savings-investment process, corporate finance decisions, and consumer portfolio choices cannot be understood without studying financial intermediation. So what is financial intermediation? When talking about financial markets we generally are talking about two kinds of markets, capital and money markets. In these markets, according to O. Gwilym (2011), the participants can be categorized into two areas; (i)......

Words: 3340 - Pages: 14

Free Essay

Theories

...The Portfolio Theory also known as Modern Portfolio Theory was first developed by Harry Markowitz. He had introduced the theory in his paper ‘Portfolio Selection’ which was published in the Journal of Finance in 1952. In 1990, he along with Merton Miller and William Sharpe won the Nobel Prize in Economic Sciences for the Theory. The theory suggests a hypothesis on the basis of which, expected return on a portfolio for a given amount of portfolio risk is attempted to be maximized or alternately the risk on a given level of expected return is attempted to be minimized. This is done so by choosing the quantities of various securities cautiously taking mainly into consideration the way in which the price of each security changes in comparison to that of every other security in the portfolio, rather than choosing securities individually. In other words, the theory uses mathematical models to construct an ideal portfolio for an investor that gives maximum return depending on his risk appetite by taking into consideration the relationship between risk and return. According to the theory, each security has its own risks and that a portfolio of diverse securities shall be of lower risk than a single security portfolio. Simply put, the theory emphasizes on the importance of diversifying to reduce risk. Early on, investors stressed on individually picking high yielding stocks to earn maximum profits. So if one particular industry was offering good returns; an investor would have......

Words: 8380 - Pages: 34