The Firm's Financing and Dividend Policies, and the Cost of External Financing Under Information Asymmetry: A Generalized Analysis

69 Pages Posted: 24 Mar 2008

See all articles by Vipin K. Agrawal

Vipin K. Agrawal

University of Texas at San Antonio - Department of Finance

Ramesh K. S. Rao

University of Texas at Austin - Department of Finance

Date Written: November 18, 2007

Abstract

Extant Information Asymmetry (IA) theories in corporate finance apply, not to all but, only to that subset of firms satisfying the theories` assumptions about: a) the nature of the manager`s private information, and b) the set of securities that can be issued. The research has noted that the conflicting empirical results in the literature my stem from the fact that the firms under study may not satisfy these assumptions. We therefore examine, in this paper, the implications of IA for the firm`s optimal financing and dividend policies, and the cost of external financing, in a framework that accommodates all natures of the manager`s private information and that places only parsimonious restrictions on the set of securities that the firm can issue. We show, using a screening model, that irrespective of the assumptions one makes about the nature of the manager`s private information, and the set of securities that can be issued, a firm will belong to one of three IA Groups, and that IA has similar implications for all firms within a Group. This surprising finding, not only yields extant IA results as special cases of our generalized framework, but it also generates new results for the firm`s optimal financing /dividend policies and reverses some standard debt-equity intuitions. For example, we find, contrary to the implications of the extant theory, that: a) firms can issue equity and, in some cases, issuing equity can be optimal when even it is accompanied by a drop in stock prices, b) equity issuance may be optimal even there is IA only about firm value and not variance, c) an increase in IA, even about value, can lead to an increase in equity issuance, and d) firms can optimally pay dividends and issue risky securities, even equity. These new results also help us reconcile some conflicting findings of the extant IA empirical research. Finally, our approach provides a rich agenda for future research. It provides suggestions for : i) conducting more powerful empirical tests on the impact of IA on the firm`s optimal policies, ii) identifying new securities (security design) that while reducing external financing costs are also likely to attract a broad-based demand from firms and iii) identifying the firm`s optimal financing/dividend policies when it can issue securities such as convertibles.

Suggested Citation

Agrawal, Vipin Kumar and Rao, Ramesh K. S., The Firm's Financing and Dividend Policies, and the Cost of External Financing Under Information Asymmetry: A Generalized Analysis (November 18, 2007). Available at SSRN: https://ssrn.com/abstract=1107952 or http://dx.doi.org/10.2139/ssrn.1107952

Vipin Kumar Agrawal

University of Texas at San Antonio - Department of Finance ( email )

San Antonio, TX 78249
United States

Ramesh K. S. Rao (Contact Author)

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-475-8756 (Phone)
512-471-5073 (Fax)

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