Student name : Minh Dai Nguyen Student number: 110063077 Module: Business Economics Tittle : Coursework 2 Number of words:

2400

INTRODUCTION In business, firms usually face situations when they have valuable investment opportunities, but they do not have sufficient internal funds to undertake these investment opportunities. To finance the investments, it is suggested that firms can seek for external sources of funds, such as debt and equity financing. However, issuing debt or equity may have various impacts on value of the companies and benefits of shareholders. Myers and Majluf (1984) created the issue-invest decision model to explain several corporate financing behaviors. In the research, the authors suggest asymmetric information between managers and investors of the firms. Asymmetric information cannot be conveyed costlessly to the investors so the true value of the firms and investment opportunities cannot be known by investors. It may result in the beneficial conflicts if the firms have to issue new equity. Myers and Majluf (1984) explained investment behaviors of firms based on the level of firms financial slack1 and the NPV2 of the investments. According to their analysis, firms tend to prefer internal to external funds, debt to equity in financing the investments. Wu and Wang (2004) extend the model of Myers and Majluf (1984) by presenting a new variables, the private benefit of managers and insiders ownership, to explain over- and underinvestment behaviors of firm. The new model concluded both private benefit and insider ownership have opposing effect on the behaviors of under-and overinvestment of the firm. Moreover, the announcement effect can be negative as well as positive. In this paper, my purpose is to summarize the theoretical models and results in these two papers. I will discuss the main differences between the two papers and give my opinions on the results and shortcoming of both theories.

Financial slack : having a sufficient level of cash, marketable securities, and real assets that are readily saleable 2 NPV: Net present value

SUMMARIZE
MYERS AND MAJLUFS MODELS

1. Research question Myers and Majluf (1984) answer the following question: How do asymmetric information affect firms issue-investment decisions? Does the financial slack affect firms decisions? What is more preferable debt or equity issue when there is asymmetric information? What is the ex ante loss of firm value? 2. Myers and Majlufs Models: Myers and Majluf (1984) created a three-date model to analyze the effect of asymmetric information on firms issue-invest decision. There are three dates marked in the model including t = - 1, t = 0 and t= +l. At the date t = - 1, the managers of the firm share the same information with the market (investors). At t=0, the true value of the firms asset-in-place (a) and NPV of investment opportunities (b) are revealed only to the management. At time t=+1 the market receive information of the value of the firms asset-in-place and NPV of investment opportunities. The firm can place its issue-investment decisions on those three dates. These decisions are assumed to be based on the benefits of old shareholders. The model rules out the cases when a , b got negative value. The amount of investment, financial slack, and required equity , required debt issue are denoted by I, S, E, D , respectively. Note that if equity is issued, the amount of equity is given by E= I S. If debt is issued, the amount of debt is given by D=I-S. The market value of firm is P if stock is not issued, P if stock is issued. Vold is the intrinsic 3 value of old shares held by old shareholders. Since management acts based on interest of old shareholders, the issue-investment decisions made by management must not reduce Vold . 4 The authors deduced the table below: Information t= -1 t= 0 t= +1 available for : (symmetric (Asymmetric (Symmetric information) information ) information ) Managers Distributions a ,b, S a, b; remaining S, and ; S if any of Market (investors) Distributions Distributions a, b; remaining S, of A and B; S; if any of and ; S and E (either E= 0 or E=IS )
true or intrinsic value means the pay off or what the shares would sell for, conditional on the firms issue-invest decision. 4 Note that the issue-investment problem disappears if manager can costlessly convey their information
3

(a,b,S) to the markets, or they can force old shareholder to buy new equity. In the case of there is no asymmetric information, issuing new equity will note reduce intrinsic value of old shares V old will not be reduced. The interest of old shareholders are guaranteed.

3. Results In case of the firm with ample financial slack (S > I), the firm does not have to issue equity to undertake the investment opportunity. Since slack allow firm to pursue the investment using internal fund, the Vold=a+b+S , so the old shareholders are better off. In case firm have ample slack and attempt to take advantages of issue new equity ( if the share is overrated), it can be a strong pessimistic signal for the market. By those reason, firms with ample slack will prefer internal funds to external funds to financing investment opportunities. Myers and Majluf interpret the value of Vold by introducing numerical examples in which issue decisions of firms are placed on different dates. In the example, Vold are likely to fall when the firm decide to issue equity in time t=0, t=+1 or firm issue share in both time. If the firm does not issue stock: Vold = S + a , if it does issuing , Vold = ( ). ( ) (1) The old shareholders are only better off when : S+a

The authors constructed the equation of the line, E+b= (S+a) (1) , which rational divides behaviors of the firm. In graph 1, if actual value of the firm asset (a) and NPV of the investment (b) fall into region M, the firm will issue and invest, otherwise the firm do nothing. So the firms decisions to issue and invest depends on the relative values of a and b. The higher the value of b is, the more likely firm is to issue and invest. The lower the value of a is, the more attractive the issue price P.

Graph 1 : Myers and Majlufs model (1984) - issue-investment decision with asymmetric information

P = (M) + S P= (M) + (M) + S. 5 Myers and Majluf explained, the decision to issue new equity always reduce the share price (P>P) if there is a room not to issue equity. The decision not to issue equity happens when a, b fall into M. Hence M is not empty. So any value of a fall into region M exceed P-S, so (M) > P- S . Hence P>P. The model helps to explain why firms seem to prefer debt to equity issuing when financing the investment. The reason is because of the higher value of Vold the debt issue will result (the firms act based on interest of shareholders) Without issuing , Vold =S+ a, with debt issue : Vold=S+a+b-D With equity issue : Vold=S+a+b-E (E and D are the gains of old shareholders by equity issue and debt issue at t = + 1) With risk-free debt, the debt is as good as the slack, so the firm always issue risk-free debt. If the debt issue is not risk-free, D may be positive or negative. Galai and Masuliss option pricing framework (1976), give us | D | < | E |, D and E is always same sign. In case of E<0, it results in capital loss for new stock holders. In case of positive sign, it results in the higher value of Vold when the debt is issued. MyersMajlufs model predicts that the firm may pass up good investment opportunities by doing nothing. This happens with probability F(M). Thus, the ex ante loss of firm value is L=F(M) (M). There is no loss when the firm has sufficient slack to finance the investment - that is, L = 0 when S>=I

(M) : The expected value of assets in place conditional on not issuing ( ) (M) : The expected value of assets in place and NPV of Investment conditional on not issuing

WU AND WANGS MODELS

1. Research question Wu and Wangs (2004) answer the following question: How do insiders ownership and private benefit affect issue-investment decision of firms? What are possible announcement effects? How does insiders ownership and private benefits affect under- as well as overinvestment. 2. Wu and Wangs theoretical model: Wu and Wang developed the three-dates issue-investment model of Myers-Majluf (1984). The model now has two new variables: w: managers/insiders share ownership (as percentage of all share outstanding) (before the issue) c: private benefits of managers which arise in new investment If the investment is passed up, the wealth of managers is w(a+S). The model gives the expected value of insiders, if the decision is to issue and invest, as
( )

(a+b+E+S-c)+c .
(a+b+E+S-c)+c (2) / . / (2)

The managers/controlling shareholders will prefer to issue equity and invest if : w(a+S) <=
( )

Wu and Wang construct a new line equation as below: .

The graph 2 give us the issue-investment decisions of managers. Similar to the model of Myers and Majluf (1984), if (a,b) lie on the region M, the decision is to issue equity and invest. In this model, there is probability of negative NPV investments. If (a,b) belong to the region M, the decision is not to issue and pass away the investments.

Graph 2 : Wu and Wangs model (2004) - issue-investment decision with asymmetric information and private benefits The graph 3 below describes underinvestment and overinvestment behaviors of firms. If (a,b) falls into the region M2, the firm underinvested; M3 the firm overinvested.

Graph 3 : Wu and Wangs model (2004) - underinvestment and overinvestment behaviors 3. Results In Myers-Majluf (1984) theory, the equity price will always drop at the announcement of the new issue. The announcement effect cannot be positive. In the new model, Wu and Wang found different changes in price of stock after a new issue. The announcement effect can be negative as well as positive. 6

At time t=0 , if the firm issue and invest, the equilibrium firm value is Pis = ( ) ( ) If the firm do nothing: Pno= ( ) At time t = -1 , investors may predict all the scenarios for time t =0 and the market 6 ) , ( ) reach the equilibrium firm value as : Pb = ( We deduct: ( )+ - , ( ) - + Pis - Pb = * ( ) *, ( )
(information about A) (information about B-c )

Scenario 1 2 3 4 5 6

(A) Information (B) information (A)+(B) effect about A about B-c + + + + + + _ + + + Table 1 : Decomposition of announcement effect

Announcement effect + + + -

In the model, the announcement effect depends on the dominant effects. If the positive effect overwhelms, price of stock will rise (Scenario 1,2,5). Otherwise the stock price drops. (Scenario 3,4,6) In the new model, the loss of firm passing up good investment opportunities by doing nothing (underinvestment) is LU=F(M2) (M2) (Similar to the old model). The new model predicts also the overinvestment. The ensuing ex ante loss of firm value is LO=F(M3)(M3), which is negative. Table 2 below gives the results of effect of c and w on loss and firm value . The results is that both private benefit and insider ownership have opposing effect on under-and overinvestment. Panel A shows, increasing private benefit c results in a reduction in LU but an aggravation in LO, firm value increasing. Panel B shows, increasing insider ownership w results in an increase in LU but an alleviation in LO, firm value decreasing.

(M+M) : the expected value of A conditional on both regions Mand M : the probability (a,b) is in region M

In panel C, when c is small, a higher insider ownership w results in a lower firm value. But when c is large, the reverse is observed, a higher insider ownership w results in a higher firm value. The authors suggest that, if a firm can freely choose c and w , they should consider a relatively small amount of private benefits and a lower level of insider ownership in order to maximize the firm value.

Table 2: the results of effect of c and w on loss and firm value

DISCUSSION Wu and Wang (2004) extent the issue-investment model developed by Myer and Majluf (1984). Both models are based on assumption of three dates time, which occurs when there is asymmetric information. The models examine the different issue-investment decision of firms. Both models recognize the effects of financial slack on issue-investment decision. The first difference is about the assumptions. The old model is based on the assumption that decisions are based on interest of the old shareholders. On the other hand, the new one is based on the interest of managers/insiders. Managers of firms try to maximum their own wealth including their entitled equity claims (insider ownership) and private benefits derived from undertaking new projects. My opinion is that the interest of managers increasingly affects their decisions. Since providing interest for managers is an essential way to create incentives for managers, without the interest, managers become less motivate, the firms fall to underinvestment. As for the suggestion of the model, owners of firms should consider a relatively small amount of private benefits and a lower level of insider ownership in order to maximize the firm value.

In the first model, the firm only invest with positive NPV projects, all negative NPV projects are ruled out, overinvestment is ruled out completely. However, in the second one, managers may be interested in negative NPV one since it may yield higher private benefit for managers. The second model is more convincing, since it happened in reality. From that assumption, the consequences of the two models can be relatively different. The stock price always falls in the old model, whereas it can fall or rise in the new model. As for the ex ante loss of firm value, it comes from the concerns over overinvestment as well as underinvestment in the new model, whereas it only comes from underinvestment in the old one. Model 1 ignores positive announcement effect. Moreover, in the first model, the authors compared the effects of debt issue and equity issue to explain why firms prefer debt to equity issue. In the second model, debt issue is not investigated.

CONCLUSION The analysis of Wu and Wang (2004) delivered significant enhancements to the model of Myers and Majluf (1984) about corporate finance and investment behaviors under asymmetric information. By providing new variables, including private benefits and insiders ownership, the model now can explain over- and underinvestment behaviors of firms as well as the positive announcement effect. There are still limitations in the model. There are a number of variables which are forgone in the model such as tax, transaction cost. Besides, the model does not examine the cost of conveying information. There are cases, firms managed to convey some parts of their information, these cases may affect the results of our model. Moreover, there are some potential related researches, such as the relationship between providing incentives, compensation for managers and the value of firms.

10

REFERENCE Myers.S.C, Majluf. N. S (1984), Corporate financing and investment decisions when firms have information that investor do not have, Journal of Financial Economics, 13, 187-221. Wu.X, Wang.Z (2004), Equity financing in a Myers-Majluf framework with benefit of control, Journal of corporate finance, Department of Economics and Finance, City University of Hong Kong, 11, 915-945.

11