The most general MMII

Adverse selection problem: Consider all-equity firm with no internal funds, Assume there are two equally likely states of nature: “good state” and “bad state” unknown to the market but known to the managers, The firm has assets in place and an investment opportunity that have different values in different states, Investment opportunity requires investment of $100, The management considers: (1) do nothing or (2) issue $100 of new equity to new shareholders and finance the project. If the market knew the state of nature, no problem: Project’s PV > 100. If the market thinks the firm issues equity for 100 in any state, it values the firm after investment as V = 0.5*370 + 0.5*240 = 305. So, for 100 of funds the new shareholders require share 100/305. The existing shareholders in the good state then get: (1 - 100/305)*370 = 248.7 < 250 Hence, they will choose not to issue equity in the good state! Hence, if the firm issues equity it must be in the bad state. Then the market believes V = 240. Let’s check if it’s indeed optimal for the firm to issue in the bad state, given the market belief. The existing shareholders then get (1 - 100/240)*240 = 140 > 130 - indeed, in the bad state the firm prefers to issue equity.=> Lemons problem. Can it be that the firm does not issue equity regardless of state? Market breakdown example: Image PV of new project is 120 instead of 160 in the last table: Show that issuing equity in both states cannot occur, Show that if the market believes that the state is bad, the firm will not issue equity (trivially, since the new project’s NPV < 0) & conclude that it cannot be that the firm issues equity only in the bad state.

To be sure, check also that it cannot be the case that the firm issues equity only in the good state (if it were the case, the market would assign high value to the equity-issuing firm => the firm in the bad state would want to pretend to be in the good state to sell heavily overpriced equity).

Solutions: issue securities that are “insensitive” to information, e.g. raise 100 by issuing risk-free debt that promises repayment of 100.It will not be underpriced => shareholders will capture the whole NPV of the project! if “good” firm issues risk-free debt, the action of “bad” firm depends on whether Project’s NPV < 0 or > 0: If Project’s NPV < 0 (e.g., when the Project’s PV is 90), “bad” firm will not want to raise funds, because that will “dilute” the existing shareholders; If Project’s NPV > 0, “bad” firm will raise funds, and is indifferent between issuing debt and issuing equity – it cannot fool the market when issuing equity, as the market perfectly realizes that the firm is “bad”.

Implication for capital structure: Pecking order theory: among the methods of financing firms should start from the one which is least sensitive to information: retained earnings (or liquid assets)=> debt => equity. Market timing view: existing capital structures are a cumulative outcome of past attempts to time the market. Simple idea: issue equity when the firm’s stock is overpriced, repurchase equity when its underpriced.