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

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“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.

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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

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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.

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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.

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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.

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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).

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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).

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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

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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:

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( ( )

)

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).

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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<