Corporate Finance

Financial contracting

Week 4

Financial contracting,

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Outline

Financial contracting and information asymmetry

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Information content of a security and mispricing

Pecking order hypothesis and the advantage of debt

Market timing and certification

Agency costs of debt and financial contracting

Financial contracting,

Risk shifting

Debt overhang

Incentives induced from a financial contract (security)

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Asymmetric information between the firm and the market

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So far we have assumed that outside investors and managers

have the same information.

Now we consider information asymmetry managers (who

act in the best interest of the existing shareholders) know
more about the true value of the firm and its investment
opportunities relatively to outsider investors.

Information asymmetry might be costly for firms adverse

selection.

A firm, at a given point in time, considers what kind of

security should it issue to finance its investment opportunities
to mitigate information asymmetry cost between the firm
and the financiers.

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Asymmetric information: example

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Two types of firms exist in the market: Good and Bad with
equal frequency. The good type has assets in place with value
$100, and the bad type with value $50.
For convenience, we assume the discount rate is zero.
A new project is available for both types, which requires an
investment of $8.5 and will provide a cash flow of $10 with
certainty. NPV of this project is $1.5. This is public
information.
Also assume that the firms have $5.1 of internal funds
available to invest (this is called slack and is denoted as S).
This means that firm value increases by $10 $5.1 = $4.9.
With slack, funds needed to raise from outside investors are
I S = $8.5 $5.1 = $3.4.

Assume the project can be financed only by equity.

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Example: full information

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How many new shares do the firms need to issue to raise the
$3.4 for investment? We assume competitive markets, so
outside financiers earn no profit.

Value of the good firm with the project is $104.9. Investors

will require G fraction of the company with the investment
$3.4
such that G $104.9 = $3.4 G = $104.9
= 3.24%.

Value of the bad firm with the project is $54.9, so investors

will require B such that
$3.4
B $54.9 = $3.4 B = $54.9
= 6.19%.

For both types, the existing shareholders capture the whole

NPV. The value of their stake with the investment is:
Good :
Bad :

Financial contracting,

(1 G ) $104.9 = $101.5,
(1 B ) $54.9 = $51.5.
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Example: asymmetric information

Now assume that the manager of each firm knows its own
type; but this is private information.

The outside investors do not know the type, they know only
the distribution of types they only know that the likelihood
of facing a Good firm is 0.5.

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Example: incentive compatibility constraints

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One possibility under asymmetric information is that firms

declare their type separate each other.

We need to check whether declaring their type is in their best

interest each type needs to be better off when telling the
truth.

The condition is called the incentive compatibility

constraint.

For both types it should hold that

Good :
Bad :

(1 G ) $104.9 > (1 B ) $104.9

(1 B ) $54.9 > (1 G ) $54.9

Because G < B , the good firm is motivated to declare its

true type, but the bad firm is better off lying mimicking the
good type (the ICC does not hold for the bad type).

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Example: incentive compatibility constraints

Investors know that bad firms do not have incentives to

report their true type investors will not charge different
rates for the two types of firms, firms will be pooled together.

Separating equilibrium, when investors charge different rates

for each type, is not possible.

Only pooling equilibrium is possible, with investors charging

just one price for both types.

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Example: pooling equilibrium

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Investors will again break even, but now they do not know
which firm they face.

They take into account the expected value with the project:
(0.5 $100 + 0.5 $50) + $4.9 = $79.9
and require fraction regardless of firm type
=

$3.4
= 4.26%.
$79.9

Note that while investors break even on average, they get a

positive payoff when facing the good firm
( $104.9 $3.4 = $1.06) and negative payoff when facing
the bad firm ( $54.9 $3.4 = $1.06).

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Example: implications of pooling

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With pooling, the good type will loose a fraction of the NPV
due to the fact that > G the good type is underpriced
by the outside investors.

It has to issue more expensive equity.

The value of the firm to the existing shareholders with the

project under pooling is:
(1 ) $104.9 = $100.44,
but it was $101.5 under full information.

The existing shareholders share the NPV with the outside

investors.

The good firm is still better off with the investment.

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Example: separating equilibrium

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For the good firm, if the cost of mispricing is larger than the
NPV, it is not worth investing.
The pooling equilibrium collapses a separating equilibrium
arises with only the bad firm investing.
In our example, assume now that S = $0. Due to the
investment, value of the firm increases by $10.
The pooling required by investors is now
$8.5
= 10%.
=
$75 + $10
Good firm:
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The existing shareholders value with the investment is

(1 ) $110 = $99, which is lower than the value of the firm
without investing $100.
This is because the equity issue with pooling is very costly
(G $110) ( $110) = $8.5 $11 = $2.5
and the NPV is only $1.5.

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Example: separating equilibrium

So, asymmetric information may result in some projects to be

forgone under-investment (deadweight cost).
Underinvestment is more likely to arise when:
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I is larger or S is smaller.

Difference in quality of firms is larger.

Proportion of higher quality firms is smaller.

NPV is lower.

In general micro-economic terms, this phenomenon is called

the adverse selection problem and is due to
Akerlof(QJE 1970).

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Example: separating equilibrium

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The separating equilibrium also means that the decision to

invest is a revelation of bad type.

Conditional on invest and issue equity, investors charge a fair

price B = $8.5
$60 = 14.2% and value of the (bad) firm with
investment is $60.

This means a negative adjustment in price as before the

investment decision the market valued all firms at $75.

So we observe a negative market reaction to new equity

offerings.

This is consistent with the empirical observation that the

market announcement of equity issues is met with a negative
market reaction.

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Application 1: pecking order hypothesis

Due to Myers and Majluf (1984).

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To explain the pecking order of using financing options in

practice.

The main idea: mispricing associated with project financing is

minimized for debt financing and is larger for equity financing.

Explains the virtues of debt.

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Pecking order: settings

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We have two types of firms in the market: Good (G) with

frequency 0.5 and Bad (B) with frequency 0.5. Their type is
private information of the manager. For convenience, the
discount factor is zero.

Both types have assets in place that generate either XH if

success or XL if failure, but they have a different probability of
success (pG = 0.6 but pB = 0.4).
Good
0.6

Bad
XH

XH

0.6

0.4

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0.4

XL

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Pecking order: settings

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Both types have an investment opportunity that requires an

initial cost of I and increases the probability of success by 0.2.
Good
0.8

Bad
XH

0.6

XH

0.4

I
0.2

XL

The NPV of the investment is the same for both types and is
positive:
0.2 (XH XL ) > I .

Both types have retained earnings S (slack) outside

financing needed is I S > 0.

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Pecking order: settings

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We want to design a financial contract that minimizes the

information asymmetry costs.
We define a financial contract as (RH , RL ), where Ri is the
dollar return to the financier if success (i = H) or failure
(i = L).
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Note that we cannot contract on firm type because it cannot

be verified in court.

We can contract only on cash flow that is verifiable we

contract on success (H) or failure (L).

When a firm claims it is of type G , its security offered is

(RHG , RLG ). Same for type B: (RHB , RLB ).
We focus on contracts that could be repaid feasible
contracts:
0 RH XH

and

0 RL XL

.
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Payoffs

For a security (RH , RL ), the payoffs to the investors are,

G = 0.8 RH + 0.2 RL (I S)
B = 0.6 RH + 0.4 RL (I S) .

The payoffs to the existing shareholders are,

UG = 0.8 (XH RH ) + 0.2 (XL RL )
UB = 0.6 (XH RH ) + 0.4 (XL RL ) .

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Pecking order: risk-free debt

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If XL > I S, the firm is raising only relatively little money

that could be paid back from the existing assets in place in
any state of nature.

So the contract repayments are

RL = I S

and RH = RL = I S.

This pay-off structure resembles risk-free debt.

Risk-free debt has no mispricing cost as it is not sensitive to

the type of the firm risk-free debt does not affect
investment.

Note that internal funds S have the same effect and also
decrease the need for external financing.

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Pecking order: pooling

Now we focus on the case where XL < I S.
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As firms now cannot cover the whole external financing in

case of failure, the contract is risky.

It could be shown that a separating equilibrium with both

types issuing does not exist the two types cannot be
separated by the securities they are offering because the bad
type will always mimic the good type.

In a pooling equilibrium good type stays in the market with

the bad type, with only one security offered by both types,
(RH , RL ).

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Pecking order: pooling

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The average success probability after investment is

p = (pG + pB ) /2 = 0.7.

The investors ask (RH , RL ) so that they break even on

average:
I S = 0.7 RH + 0.3 RL

On average, they make no profit:

= 0.7 RH + 0.3 RL (I S) = 0

But they profit when financing the good firm:

G =0.8 RH + 0.2 RL [0.7 RH + 0.3 RL ]
G =0.1 (RH RL )

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Pecking order: pooling

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The good types value with investment (and after financing)

under pooling is
0.8 (XH RH ) + 0.2 (XL RL ) + =
0.8XH + 0.2XL (I S) fair value
0.1 (RH RL ) mispricing

Security design: the best the good type can do is to minimize

(RH RL ), subject to
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feasibility conditions
0 RH XH

and

0 RL XL

and investors breaking even

0.7 RH + 0.3 RL = I S.

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Optimality of debt
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To minimize (RH RL ) we want RH = RL a constant

payoff.

However, subject to feasibility condition RL XL (the firm

can pay off only as much as the cash flow), the best we can
do is to pay as much as possible in the failure state RL = XL
and limit the payoff in the success state.

The solution is a debt contract:

RL = XL
RH

= XL +

I SXL
0.7

feasibility condition
= B break even condition

The result can be generalized to any distribution.

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Optimality of debt

RH
RL

XL

XH

Debt Payoff

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Pecking order: debt versus equity

We have just shown that mispricing is minimized by a debt

contract.

Mispricing is larger for an equity contract where investors

demand a fraction of equity such that
[0.7XH + 0.3XL ] = I S

With an equity contract, payment if success depends on XH

and cannot be limited mispricing is larger relatively to debt.

Equity is more information sensitive.

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Two Key points

1. Cost of external financing

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Asymmetric information might motivate firms not to raise

external financing and forgo positive NPV projects.

This cost is avoided if firms could rely on internally generated

funds.

2. Advantage of debt over equity

Financial contracting,

Debt relatively to equity is a security that has smaller cost due

to mispricing.

Firms prefer to issue debt until all their debt capacity is used.

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Application 2: market timing

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Empirical observation: equity issues are more common after

firms stock price or stock market rises.

Intuition adverse selection (mispricing) is less relevant in

booms.

Example: we have good and bad types distributed with equal

probability. They have an investment opportunity with initial
investment I = $10 that brings a cash flow of $20 with
probability 0.7 for good firms and probability 0.6 for bad firms
and $0 otherwise.

The full-information returns for investors would be

I
$10
RG = pIG = $10
0.7 and RB = pB = 0.6 . Under full information,
the whole NPV is captured by the existing shareholders:
NPVG = 0.7$20$10 = $4

Financial contracting,

NPVB = 0.6$20$10 = $2

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Application 2: market timing

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= I = $10 , where
The pooling return charged is R
p

0.65
p = 0.7+0.6
.
2
The part of NPV the good firm looses with pooling:
0.7 $20

$10
(0.7 $20 $10) = $3.23 $4 = $0.77
0.65

.
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Market boom is modeled by increasing the probability of

success by 10% to 0.8 and 0.7 for the two types, respectively.
= $10 and the part of NPV
The pooling return charged is R
0.75
the good firm looses is:
0.8 $20

$10
(0.8 $20 $10) = $0.66
0.75

.
So better market conditions imply smaller mispricing and so
firms are more willing to issue equity.

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Application 3: certification

Certification involves disclosure of hard (verifiable)

information or monitoring by third parties for a fee.

Firms can reduce information asymmetry by borrowing from

well-informed investors or by asking them to certify the quality
of the issue underwriters, rating agencies, auditors, venture
capitalists.

The certifying agencies must have incentives to become

informed and convey the information to the market
(reputation helps).

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Application 3: certification
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As in the previous example: we have good and bad firms with

equal frequency. They have an investment opportunity
requiring an investment of I = $10 that brings a cash flow of
$20 with probability of 0.7 for good firms and probability of
0.6 for bad firms and $0 otherwise.

The good firm has an incentive to pay for certification at cost

c > $0 that perfectly reveals the firm type.

If c = $0.5, the return charged with certification is

RG = $10+$0.5
= $15.
0.7
= $10 = $15.38 without certification.
While it was R

The good type will prefer certification as long as

0.65

$10 + c
$10
<
0.7
0.65
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c < $0.77
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Implications of asymmetric information theories

On average, the market reaction to announcements of equity

financing is negative.

The market reaction to debt issuance is a lot milder.

Profitable firms use less leverage.

Companies like financial slack.

Equity issues are more frequent in stock-market booms.

Certification is a costly mechanism that lowers information

asymmetry costs.

Information asymmetry theories do not predict target leverage.

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Debt-equity conflicts and security design

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We come back to debt-equity conflicts and show that different

securities (different payoff structures) induce different
incentives. Clash of incentives is costly.

Equity has convex while debt concave payoffs.

Shareholders and debtholders have different preferences

towards riskiness of projects, especially close to financial
distress (close to the kink in their payoff structure) risk
shifting.

In financial distress, due to debt overhang shareholders do

not have incentives to invest additional funds that would only
increase the value of debt under-investment due to Myers
(1977).

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Risk shifting: example

Assume a firm that lasts for one period. Probabilities are the
risk-neutral probabilities. Let rf = 0.

The entrepreneur has no funds available. He needs to raise

I = $400 for investing in a project. The funds must be raised
before the entrepreneur decides which project to invest in.

After the funds are raised, the entrepreneur can choose

between two mutually exclusive projects: Risky or Safe.

The entrepreneurs choice cannot be verified, so it is not

written in a contract the entrepreneurs choice is
non-contractible.

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Risk shifting: example

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The returns of Risky and Safe at the end of the period are:

0.4

Risky
$800

Safe
$600

$200

$400

$400
0.6

Capital markets are competitive and therefore prices of

securities are determined such that outside investors
(financiers) just break even.

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No need for external financing

For a moment, lets assume that the entrepreneur can finance

the investment opportunity himself no need to raise
external financing.

The entrepreneur would choose Safe because NPVS > NPVR :

NPVS = 0.4 $600 + 0.6 $400 $400 = $80
NPVR = 0.4 $800 + 0.6 $200 $400 = $40

We refer to this result as the first best.

The first best might not be achieved in case the entrepreneur

issues external financing.

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Equity financing
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Now assume that the entrepreneur offers a fraction < 1 of

the projects equity to an outside investor.
The entrepreneur retains a fraction 1 .
The entrepreneur will choose the safe project:
(1 ) [0.4 $600 + 0.6 $400] >
> (1 ) [0.4 $800 + 0.6 $200]

Anticipating the choice of the entrepreneur, the outside

equityholders require a fraction as compensation for the
investment of I = $400:
[0.4 $600 + 0.6 $400] = $400

5
= .
6

that is, 83.3% of firms equity is offered to the outside

shareholders to raise I = $400 for investment.
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Equity financing
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The entrepreneur enjoys the whole profit from the project



5
1
[0.4 $600 + 0.6 $400] = $80,
6
which is greater than if he took the risky project:


5
1
[0.4 $800 + 0.6 $200] = $73.
6

Equity financing achieves the first best: the entrepreneur

and the financier are holding the same security, and their
interests are aligned.

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Debt financing
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Now, lets consider debt financing.

The entrepreneur issues debt with face value B to raise the

$400 for project investment.

The entrepreneurs payoffs for Risky and Safe:

0.4
0

Safe
$600 B

0.6

Financial contracting,

Risky
$800 B

$0

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Debt financing
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B depends on the project type.

If the entrepreneur chooses Safe, the financier asks:

0.4 B + 0.6 $400 = $400

B = $400.

But given B = $400, the entrepreneur will choose Risky

because the project type is non-contractible:
0.4 ($800 $400) > 0.4 ($600 $400).

The financier anticipates the choice of the entrepreneur and

asks for B such that he brakes even for Risky:
0.4 B + 0.6 $200 = $400

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B = $700.

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Debt financing
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To summarize, the entrepreneur strictly prefers Risky if debt

is issued to finance the project.

Under debt financing, the entrepreneur and the financier are

holding different claims, and thus their interests are
misaligned.

In our example, this is because Risky looses a cash flow in the

bad state of nature, but the entrepreneur does not care about
this cash flow it is cash flow lost to debtholders.

In case this neglected value is higher than the NPV difference

of the two projects, the entrepreneur chooses Risky project
we have an inefficiency (project with lower NPV is chosen).

It is very important to note that risk shifting occurs only in

case of financial distress cash flows are lost in the bad
state of nature that entrepreneur does not care about.

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Debt financing: no financial distress

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To illustrate the point, assume that the projects require only

$250 of initial investment.

Safe is still the first best:

NPVS = 0.4 $600 + 0.6 $400 $250 = $230
NPVR = 0.4 $800 + 0.6 $200 $250 = $190

Debt is still risky for the Risky project, but the value lost is
only 0.6 ($250 $200) = $30, which is smaller than the
NPV difference.

The entrepreneur does not have motivation to switch projects

any more, with B = $250 for Safe, he prefers Safe:
0.4($800 $250) < 0.4($600 $250) + 0.6($400 $250)
220 < 230.

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Payoff structures
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In general, the different securities are associated with

different payoff structures and so induce different risk
attitudes and different incentives.

The firm value is divided into risky debt and levered equity:
a concave claim and a convex claim.

The convex claim holder, the entrepreneur (levered

equityholder) has incentives to take excessive risks. By doing
so, he increases the equity value while decreasing the debt
value: risk shifting or asset substitution.

The convexity of levered equity is due to limited liability an

economic institution that encourages risk taking and
entrepreneurship.

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Pay-off structures
R

Slope = 1

B
Debt Payoff = min{A, B}

Financial contracting,

A
B
Equity Payoff = max{A B, 0}

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Debt overhang: example

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We have a one-period model with rf = 0. We again use

risk-neutral probabilities.
At t = 0, an entrepreneur runs a firm with assets in place that
generate cash flows at t = 1:

0.5

assets
$3000

debt
$2000

$1000

$1000

0.5
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The debt in the firms balance sheet has face value of

B = $2000. The firm is only solvent in the high state.
We have a debt overhang.
= $1500.
The value of debt is D = $2000+$1000
2

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Debt overhang: example

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At t = 0, the entrepreneur has also an investment opportunity

that requires an investment cost of $300 and increases cash
flow in both states by $400:

0.5

assets
$3400

debt
$2000

equity
$1400

$1400

$1400

$0

$300
0.5

The project has positive NPV: NPV = $400 $300 = $100.

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Misalignment of interests
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If the project is taken, the value of debt in the default state

increases, and the total value of debt increases by
D = 0.5 $400 = $200.

But the equity value changes by

E = 0.5 $400 + 0.5 $0 $300 = $100.

Even though the project itself has a positive NPV, the

investment would decrease the value of equity.

Investment here is like a free lunch for debt holders they do

not bear the cost of investment, but enjoy all the benefits.

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Debt renegotiation
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Lets consider a case in which the debtholders offer a debt

relief conditional on the investment to be undertaken.

In the offer, the outstanding debt is reduced to a new level B 0

such that the price of debt is unchanged
0
+ 0.5 $1000}
0.5
0.5 $1400} = 0.5
| $2000 {z
| B +{z
New Debt
Old Debt

B 0 = $1600.
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So, the offer implies no transfer of wealth from equity to debt.

However, there is a transfer of wealth for the debtholders from
the good to bad state of nature.

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Debt renegotiation

Under the new debt level, the equity value if investment is

taken is
0.5 ($3400 $1600) = $900.

The equity value with no debt relief, and therefore if the

investment is not taken is
0.5 ($3000 $2000) = $500.

The increase in equity value is larger than the investment cost

of $300 and the entrepreneur would be happy to renegotiate.

The debtholder is indifferent.

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Debt renegotiation
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Renegotiation could restore efficiency.

However, the debt relief needs to be conditioned on

undertaking the investment project.

In reality, such a condition is very difficult to verify.

If this is the case, the entrepreneur is not motivated to invest

once he is granted the debt relief because
0.5 ($3400 $1600) $300 < 0.5 ($3000 $1600)
$600 < $700

The debtholder, expecting this, is not willing to offer the debt

relief.

Thus, debt relief is difficult to implement even if both parties

are aware of the large cost associated with debt overhang.

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Implications

Debt overhang has general implications beyond our simple

example.

As debtholders claim part of the firm value, but the

shareholders pay the investment cost to create value, the
misalignment of interests is always present.

Debt overhang is also consistent with the empirical evidence:

Firms with growth opportunities and investments have lower
leverage.

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Implications
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Risk-free debt does not induce under-investment.

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In our example, if the existing debt B = $1000, the debt is risk

free and the firm is always solvent equityholders capture the
all the NPV in all states and no under-investment is observed.
Financial distress is the driving force for under-investment.

Short-term debt can alleviate debt overhang.

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Financial contracting,

When debt maturity is long, shareholders have more

investment opportunities (part of) which could be captured by
debtholders.
With short-term debt, new debt could be issued facing new
investment opportunities: as if the shareholders can always
renegotiate.

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Summary: Agency cost of debt

Two major agency costs of debt: risk shifting and debt

overhang.

The payoff structure of the security matters and affects

investment decisions debt is costly.
Two fundamental reasons:

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Equityholders decide about investment.

Equityholders have limited liability convex pay-off structure.

The agency frictions between equity and debtholders imply

that debt is associated with frictions that translate into costs.
The asymmetric information theories show the virtues of debt.

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Summary of the lecture: security design

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Information asymmetry between firms and outside investors

has important implications for security design.

An important advantage of debt is that it is less sensitive to

adverse selection.

Firms prefer internal financing that does not suffer

information cost. This is consistent with the empirical results
that profitable firms are less levered.

Agency costs of debt have also important implications from

the point of view of security design. Different payoff
structures imply conflicts of interests and perverse incentives
in financial distress we observe risk shifting and
under-investment.

Financial contracting,

Corporate Finance

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