Ebook Cash Flow Correlation, Debt Maturity Choice, And Asymmetric Information
A significant component of finance literature is concerned with the choice of capital structure. Most of this literature, though, has ignored the associated problem of debt maturity structure. Research that has modeled the choice of debt maturity can be divided into two streams. The first contains papers that relate anticipated interest rate changes and the term structure of interest rates to debt maturity decisions. For example, Morris (1976) explains the maturity structure decision in terms of the correlation between future interest rates and firm net operating income, and Brick and Ravid (1985) rely on tax considerations to argue that the optimal debt maturity is a function of the term structure of interest rates.
Papers in the second stream rely on agency theoretic arguments and asymmetric information to explain debt maturity decisions. For example, Barnea, Haugen, and Senbet (1980) argue that short-term debt acts as a bonding device, resolving the conflict of interest between stockholders and bondholders that arise due to information asymmetry and moral hazard. On the other hand, Flannery (1986) and Diamond (1990), use a signaling framework to explain the debt maturity decision. They focus on the debt maturity decision when firms' cash flows are independently distributed over time.
Employing the assumption that firm cash flows are independently distributed over time, Flannery (1986) obtains separating equilibria in which short-term debt signals that a firm is good and long-term debt signals that it is bad, when floatation costs are sufficiently high. Diamond (1990) obtains a similar result when there exists a limit to the future rents that can be assigned to investors in the market, that is, liquidity risk. With regard to pooling equilibria, Diamond (1990) demonstrates that, when liquidity risk is sufficiently small, there exist pooling equilibria in which, regardless of its type, a firm issues short-term debt. In Flannery (1986) these equilibria obtain when flotation costs are sufficiently low.
We depart from the previously discussed literature by systematically analyzing the effect of intertemporal cash flow correlation on the debt maturity decision in the context of a signaling scenario. In the context of a two-period model, we consider the case of a firm that has an opportunity to invest in a positive NPV project that generates cash flows at the end of both periods. To finance the project, the firm can issue either long-term debt or short-term debt. Following Myers and Majluf (1984), and Giammarino and Lewis (1990), the manager or insider making the financing decision, is assumed to maximize current shareholder wealth.
The insider possesses private information regarding firm quality (firm type), while the remainder of the agents in the economy know only the probability distribution over firm types. Project output and the intertemporal correlation of cash flows are assumed to depend on firm type, with output under a good firm, from a date zero perspective, dominating output under a bad one.
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