Question

How does asymmetric information create an incentive to use debt financing?

Answer 1

Asymmetric information create an incentive to use debt financing:-

Asymmetric information is an information which only the insiders know the quality of the firm, it is claimed that debt, even if it is risky, is more advantageous than outside equity because issuance of debt is less attractive to inferior firms. The advantage to debt arises from the fact that it can keep unprofitable firms out of the market, thus improving the average quality of firms in the market. This advantage exists even if the firms cannot be perfectly sorted in the signaling equilibrium.

Asymmetric information creates an incentive to use debt financing. The use of debt financing, however, distorts the continuation decision of equity holders. Debt covenants become a valuable contracting device in this environment. The model offers several predictions regarding the use of debt covenants and their relationship with the capital structure decision of the firm.

The asymmetric information at the time of financing motivates the use of debt (Myers and Majluf (1984)) and the bond covenant is used to (imperfectly) control the resulting agency problems and provides the implications for the asymmetric information at the time of the liquidation decision

Strictly speaking the capital constraint should be written as a weak inequality, however given that the manager of a good firm sells securities under asymmetric information it will never be optimal to raise more than is required.

Asymmetric information at the time of financing (time 0) implies that, all else equal, there is a pecking order for external financing in that the entrepreneur prefers 11 to issue first risk less debt to the extent possible (F = L) and then risky debt to its point of informational equality with external equity (F = Q). Once this level of debt financing is reached, the entrepreneur is indifferent between issuing more debt or external equity

The current model shows that when we extend a model of financing choice under asymmetric information to consider the costs associated with the use of risky debt, a good firm’s incentive to use debt is limited by the distortion to the incentives of the bad type firm. Because the firms are observationally equivalent, the market, anticipating the distorted incentives associated with large amounts of debt for a bad firm, will “charge” a good firm for the anticipated inefficient decision-making. This makes the use of large amounts of debt sub optimal. In this version of the model, there is a pecking order for financing choices but the point at which firm’s turn to external equity, FL the firm’s debt capacity, is very low.

Interestingly, in the case of costless renegotiation, asymmetric information does not provide a motivation for the use of debt financing. Rather a good firm is indifferent between low debt ( ) L F F  with no covenant and high debt ( ) H F F  with a covenant that assigns control of the liquidation decision to the lender in a weak market (anticipating the good firm will renegotiate in a bad market). The benefit associated with initially issuing a large amount of debt is just balanced by the cost to a good firm of separating from bad firms in the event of a weak market.

Conclusion

The capital structure decision is examined in a setting with asymmetric information as the sole friction. The model is an extension of Myers and Majluf (1984) where the implication of having debt in the capital structure under a condition of asymmetric information is considered at the time of financing. We demonstrate that an optimal capital structure may be derived trading off the benefits of selling debt, based on its low information sensitivity, and the costs of debt, derived from the inefficient decision making implied by transfers of control to uninformed parties.