In this study, I propose a model of financing decisions in an environment with dynamic asymmetric information. In this setting, the choice of security depends not only on the current adverse selection cost of the security but also on the future information environment and future financing needs of the firm. When managers anticipate an increase in the asymmetric information, even though they have private information at present, managers may choose to issue equity. The goal is to determine the optimal sequence of securities as a function of the size and dynamics of the asymmetric information advantage that insiders of the firm have with respect to outside investors.
I use dispersion of analyst forecast for different horizons, the probability of informed trading measure and analyst following to find support for my hypothesis. I find that the dispersion of analyst forecasts for the current year and following year have markedly different effects on the capital structure decisions of the firm which are consistent with firms trying to minimize adverse selection cost intertemporally.
Since the seminal research by Myers (1984) and Myers and Majluf (1984) it has been recognized that when it is impossible or costly for firms to convey the true value of their assets to outside investors, firms may be forced to forgo projects with positive net present value. In reaction companies optimally choose to use sources of funds that are insensitive to the information advantage of insiders. When managers know more about the mean expected returns, this leads to the classical pecking order of using all internal funds first and if additional capital is needed to be raised, debt should be issued. Equity should be issued only as a last resort when the leverage is at a very high level at which the firm has exhausted its debt capacity.
In fact however, companies make a sequence of financing decisions over time. It is clear that myopically following the pecking order rule is not going to be optimal for a big proportion of firms. It is natural that insiders, namely the managers running the company, would do better if they minimize the adverse selection costs of all rounds of financing by picking an optimal sequence of securities. Although Myers and Majluf (1984) do not consider the dynamic issues explicitly, one solution that they propose for the single period problem suggests a remedy for the dynamic problem. If managers do not have an information advantage at some point before the investment has to be made, companies should build financial slack to be used later when the valuations of insiders and outsiders diverge.
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Dynamics of Asymmetric Information and Capital Structure
