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
Date Written: November 18, 2007
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.
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