Corporate Finance:

Asymmetric information and capital

structure signaling
Yossi Spiegel
Recanati School of Business
Ross, BJE 1977
The Determination of Financial
Structure: The Incentive-Signalling
Approach
Corporate Finance 3
The model
The timing:
Cash flow is x ~ U[0,T], where T {L,H}, L < H
T is private info. to the firm
The capital market believes that T = H with prob.
In case of bankruptcy, the manager bears a personal loss C
The managers utility: U = V C x Prob. of bankruptcy
The firm issues
debt with face
value D
Stage 0 Stage 2
Stage 1
The capital market
observes D and
updates the belief
about the firms type
Cash flow is realized
Corporate Finance 4
The full information case
The value of the firm when T is common knowledge:
With uniform dist.:
The managers utility:
The manager will not issue debt
T
D
C x D F C x U
T T
= =

) (

( )
T
T
D
T
D
D
T
x x dF D x x DdF x xdF V

) ( ) ( ) (
0
= +
(

+ =

2 /

T x
T
=
Corporate Finance 5
Asymmetric information
D
T
* is the debt level of type T
B* is the prob. that the capital market
assigns to the firm being of type T
Perfect Bayesian Equilibrium (PBE),
(D
H
*,D
L
*,B*):
D
H
* and D
L
* are optimal given B*
B* is consistent with the Bayes rule
Corporate Finance 6
Bayes rule
In our case, two levels of D are chosen. Suppose the probability that each type
plays them is as follows:
Having observed D
1
the capital market believes that the firm is type H with
prob.:
In a sep. equil., h
1
= 1 and l
1
= 0. In a pooling equil., h
1
= l
1
= 1
( )
( )
( ) B P
A P A B P
B A P
) ( |
| =
l
2
l
1
Type L (1)
h
2
h
1
Type H ()
D
2
D
1
( )
( )
( ) ) 1 (
) ( |
|
1 1
1
1
1
1


+
= =
l h
h
D P
H P H D P
D H P
Corporate Finance 7
Separating equilibria: D
H
* D
L
*
The belief function:
In a separating equil., D
L
* = 0 because
type L cannot boost V by issuing debt
D
L
* = 0 B*(0) = 0 V(0) = L/2

=
=
=
w o
D D
D D
B
L
H
/ '
* 0
* 1
*

Corporate Finance 8
Separating equilibrium
The IC of H:
The IC of L:
Indifference of type T between V and D:
{
0 D when
H of Payoff
D issues it when
H of Payoff
2
=

L
H
D
C V
43 42 1
{
43 42 1
D issues it when
L of Payoff
0 D when
L of Payoff
2 L
D
C V
L

=
{
T
D
C
L
V
T
D
C V
L
+ = =
=
2 2
V value induces it if
D issuing when Payoff
0 D if
Payoff
43 42 1
Corporate Finance 9
The set of separating equilibria
D
L
D
C
L
V + =
2
H
D
C
L
V + =
2
2
H
V =
2
L
V =
V
D* D**
sep. equil.
D* is defined by
L/2+CxD/L = H/2
D* = (H-L)L/2C
Corporate Finance 10
The DOM criterion
D D* is a dominated strategy for type L: D = 0 always guarantees L a higher
payoff no matter what the capital market believes
The DOM criterion:
The idea: type L will never play D D* while type H might. Hence, if D D*,
then the firms type must be H
The DOM criterion still does not determine the beliefs for D < D* and D 0
Under the DOM criterion: D
L
* = 0, D
H
*=D*

=
=
=
w o
D D
D D
D D
B
L
H
/ '
* 1
* 0
* 1
*

Corporate Finance 11
Separating equilibria under the
DOM criterion
D
L
D
C
L
V + =
2
H
D
C
L
V + =
2
2
H
V =
2
L
V =
V
D* D**
D
L
* = 0, D
H
*=D*
Corporate Finance 12
Pooling equilibria: D
H
* = D
L
* = D
p
*
The belief function:
In a pooling equil., the choice of D
p
*
is uninformative; hence

=
=
w o
D D
B
p
/ '
*
*

( )
2
1
2

L H
V + =
Corporate Finance 13
The set of pooling equilibria
D
L
D
C
L
V + =
2
H
D
C
L
V + =
2
2
H
V =
2
L
V =
V
D* D**
pooling
equil.
V V

=
Corporate Finance 14
The DOM criterion
The DOM criterion:
The DOM criterion eliminates some
pooling equilibria but not all

=
=
w o
D D
D D
B
p
/ '
* 1
*
*

Corporate Finance 15
The set of pooling equilibria
D
L
D
C
L
V + =
2
H
D
C
L
V + =
2
2
H
V =
2
L
V =
V
D* D**
pooling
equil.
V V

=
Corporate Finance 16
The intuitive criterion
Due to Cho and Kreps, QJE 1987
Fix a equilibrium (D
L
*, D
H
*) and consider a deviation from this
equilibrium to D. If the deviation never benefits type x (even if it
induces the most favorable beliefs by the capital market) but can
benefit type y, then the deviation was played by type y
The intuitive criterion:
The intuitive criterion still does not determine the beliefs everywhere

=
=
w o
D D
D D
B
p
p
/ '
* by dominated is 1
*
*

Corporate Finance 17
The set of pooling equilibria under
the intuitive criterion
D
L
D
C
L
V + =
2
H
D
C
L
V + =
2
2
H
V =
2
L
V =
V
D* D**
pooling
equil.
V V

=
The intuitive
criterion
eliminates all
pooling equil.
Corporate Finance 18
Conclusions
The only equilibrium which survives the intuitive
criterion is D
L
* = 0 and D
H
* = D*
This equilibrium is the Pareto undominated separating
equilibrium and it is called the Riley outcome
Debt can be used as a signal of high cash flow
The debt of type H:
D* when L, H-L, and C, D* is independent of !
( )
C
L L H
D
H
L
D
C
L
2
*
2 2

= = +
Leland and Pyle, JF 1977
Informational asymmetries, financial
structure, and financial intermediation
Corporate Finance 20
The model
The timing:
Cash flow is x ~ [0,), with Ex = x
T
and Var(x)=
2
, where T {L,H}, x
L
< x
H
T is private info. to the firm
The capital market believes that T = H with prob.
The entrepreneurs expected utility:
An entrepreneur
sell a fraction 1- of
the firm to outside
equityholders
Stage 0 Stage 2
Stage 1
The capital market
observes 1- and
updates the belief
about the firms type
Cash flow is realized
( ) ( )V x W W Var
b
EW W EU
T T T T
+ = = 1 ) (
2
Corporate Finance 21
The full information case
The variance of W
T
:
The entrepreneurs expected utility:
Under full info., V = x
T
:
* = 0 The entrepreneur will sell the entire firm
Why? Because the entrepreneur is risk-averse and the capital
market is risk-neutral
( ) ( ) ( )
( ) ( )
2 2
2
2
1


= =
+ =
T
T T
x x E
EW V x E W Var
( ) ( )
3 2 1
4 43 4 42 1
) (
2 2
2
1
x Var
EW
T T
b
V x W EU
T
+ =
( )
2 2
2
=
b
x W EU
T T
Corporate Finance 22
Asymmetric information

T
* is the equity participation of type T
B* is the prob. that the capital market
assigns to the firm being of type T
Perfect Bayesian Equilibrium (PBE),
(
H
*,
L
*,B*):

H
* and
L
* are optimal given B*
B* is consistent with the Bayes rule
Corporate Finance 23
Separating equilibria:
H
*
L
*
The belief function:
In a separating equil.,
L
* = 0 because
type L cannot boost V by keeping equity

L
* = 0 B*(0) = 0 V(0) = x
L

=
=
=
w o
B
L
H
/ '
* 0
* 1
*

Corporate Finance 24
Separating equilibrium
The IC of H:
The IC of L:
Indifference of type T between V and :
( )
{
0 when
H of Payoff
firm the of fraction a keeps he when H of Payoff
2 2
2
1
=
+


L H
x
b
V x
4 4 4 4 3 4 4 4 4 2 1
{
( )
4 4 4 4 3 4 4 4 4 2 1
firm the of fraction a keeps he when L of Payoff
2 2
0 when
L of Payoff
2
1


b
V x x
L L
+
=
{
( )

= + =
=
1 2 1 2
1
2 2
V value a induces it if firm the of
fraction a keeping when Payoff
2 2
0 if
Payoff
b x x
V
b
V x x
T L
T L
4 4 4 4 3 4 4 4 4 2 1
Corporate Finance 25
The set of separating equilibria

+ =
1 2
2 2
b
x V
L
H
x V =
L
x V =
V
* **
sep.
equil.

=
1 2 1
2 2
b x x
V
H L
( )
2
*
2

b
x x
Z Z Z Z
L H

+ + =
Corporate Finance 26
The Riley outcome
Using Ls IC, the ownership share of type H is:
* increases with Z which
increases with the extent of asymmetric info., x
H
-x
L
decreases with risk aversion, b
decreases with the variance of cash flows,
2
Using Hs IC:
** < 1 iff 2(x
H
x
L
)< b
2
; otherwise, type H prefers every > 0 over = 0
provided that he convinces outsiders that the firms type is H
{
( )
{
( ) 2 *
2
1
2
H is type his that believes market the and
firm the of fraction a keeps he when L of Payoff
2 2
0 when
L of Payoff
+ + = + =

=
Z Z Z
b
x x x
b
x x
H L L
L H


4 4 4 4 3 4 4 4 4 2 1
{
( )
( )
2
H is type his that believes market the and
firm the of fraction a keeps he when H of Payoff
2 2
0 when
H of Payoff
2
* *
2
1

b
x x b
x x x
L H
H H L

= + =
=
4 4 4 4 3 4 4 4 4 2 1