# Myers Majluf

```Issuance of securities under asymmetric information
(Myers/Majluf 1984)
1. Empirical validity of the theorem of irrelevance
2. Model assumptions of the Myers/Majluf approach
3. An underinvestment equilibrium
4. A numerical example
5. The Pecking Order Theory
6. Information costs under different institutional frameworks
1. Empirical validity of the theorem of irrelevance
Price variation in response to stock emissions at US capital
markets
Average 2-day-excess returns at the time of the announcement
Kinds of stocks:
Excess returns of stocks emitted by industrial firms:
Common stocks
-3,14%
Preferred stocks
-0,19%
Convertible preferred
stocks
-1,44%
Convertible bonds
-2,07%
Straight bonds
-0,26%
Source: Quelle:Smith (1986): Investment Banking and the Capital Acquisition Process,
Journal of Financial Economics, Vol. 1, S. 5
2. Model assumptions of the Myers/Majluf approach
Characteristics of a perfect capital market
1. Same market entrance conditions for all market participants, possibility of
unlimited borrowing, short-selling, only one interest rate (borrowing rate =
lending rate)
2. No transaction costs, no tax
3. Everyone acts as a price taker
4. Symmetric and efficient information,
5. No arbitrage possibilities
Notation of Myers/Majluf (1984)
I = Investment volume of additional investment
S = Investable reserves of the firm, liquidity („financial slack“)
E = Issuing volume
P = Market value of old shares if event: no emission
P&acute;= Market value of old shares if event: emission
a = Net present value of the present investment, as a random variable A~ ,
~
with market value equal to expected value A = E ( A)
b = Present value of the additional investment, as a random variable B~ ,
~
with market value equal to expected value B = E ( B )
Va(E) = Market value of old shares given an emission of E
Information Structure in Myers/Majluf (1984)
Time:
t = -1
t=0
t=1
Manager’s Insider
Information:
Distribution of
~
~
A and B , S
a, b, S
a, b,
residual S
Information open
to the public :
Distribution of
~
~
A and B , S
Distribution of
~
~
A and B , S, E
a, b,
residual S
Symmetric
information
Asymmetric
information
Symmetric
information
Raise capital or
invest?
Pay off
=&gt;
Decision of
Management
3. An underinvestment equilibrium
Underinvestment in Myers/Majluf (1984)
b
Region M&acute;: Invest and raise capital
b = (E/P&acute;(S+a)) - E
Region M: No Investment
a = -S
a = P&acute;-S
b = -E
a
Market equilibrium given asymmetric information
Supply of stocks:
Management raises capital and invests, if
V a ( E = I ! S ) &quot; V a ( E = 0)
=&gt;
P!
( E + S + a + b) &quot; S + a
P! + E
=&gt;
E +b !
E
(S + a)
P&quot;
Demand for stocks:
At the stock exchange, the firm receives a market price conditional on the
market participant’s perception of the distribution of a and b as well as their
knowledge of the manager’s investment strategy.
Given an emission, the market price is
P ! = S + A ( M !) + B ( M !)
~
A ( M #) &quot; E ( A E = I ! S ), and
~
with
B ( M #) &quot; E ( B E = I ! S )
4. A numerical example of Myers/Majluf (1984)
state:
s11
s12
s21
s22
pij:
1/4
1/4
1/4
1/4
A:
20
20
6
6
b:
4
2
4
2
Given: S = 0, I=10 and hence E = 0 or E = 10.
If the management invests in each state, it follows:
P ! ( E = 10&quot;s) = 1 4 # 24 + 1 4 # 22 +1 4 # 10 + 1 4 # 8 = 16
Mistake 1:
Va11
Va12
Va21
Va22
20,92
19,69 (&lt;20!)
12,31
11,07
If the management abstains from Investing in s12, it follows:
P !( E = 0 s12 , E = 10 sonst) = 1 3 &quot; 24 +1 3 &quot; 10 + 1 3 &quot; 8 = 14
Mistake 2:
Va11
Va21
Va22
19,83 (&lt;20!)
11,67
10,50
If the management abstains from investing in s11 and s12, it follows:
P !( E = 0 s12 , s11 , E = 10 sonst) = 1 2 &quot; 10 +1 2 &quot; 8 = 9
Va11
Va12
Investment:
No investment:
20
20
Va21
Va22
9,47
8,53
Numerical example of Myers/Majluf,
Dotted lines between M and M&acute; at S = 0 and S = 5
b
4
s21
s11
2
s22
s12
6
9
20
b = (E/P&acute;(S+a))-E S=5
b = (E/P&acute;(S+a))-E S=0
-10
a
5. The Pecking Order Theory
1. If possible, firms prefer internal financing.
2. Dividends are tried to be kept constant over time. Positive operating cash
flows should be used to reduce debt or to be invested in tradeable
securities. Negative cash flows should be compensated by raising debt or
3. In case of need for external financing, the firm will prefer debt over risky
equity. That is, the firm will raise capital according to the “Pecking
Order” that ranks different sources of financing, if the internal sources of
financing are depleted.
Firstly the firm will make use of
- debt (credits and bank loans, Eurobonds of different kinds), thereafter
- hybrid securities (convertible or option bonds, participation papers,
obligations), and finally
- stock emissions.
6. Information costs under different institutional
frameworks
Sources of finance of corporates from 1970-1985
(apart from financial firms) in percentage
USA
Retentions
Capital transfers
66,9
UK
66,9
0
72,0
Germany
74,9
2,9
1,4
Loans
23,1
21,4
21,1
8,4
2,8
2,2
Bonds
9,7
0,8
0,7
Shares
0,8
(Eckbo/Masulis (1995))
-10,2
0,8
2,3
4,9
-7,2
61,9
6,7
Short-term securities
Other/Statistical
42,6
55,2
27,3
4,9
0
2,1
11,9
24,0
2,1
Price variations in response to stock emissions at the
German market
Average 2-day-excess returns at the time of the announcement
Kinds of stocks:
Stock excess returns of the examined companies:
Common stocks
0,89%
All option bonds
0,40% (insignificant)
Option bonds cum rights
Option bonds ex new
1,41%
0,10% (insignificant)
Following 30 days -1,04%
(Padberg (1995), p. 235, Entrup (1995), p. 169, 181, 201)
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