Corporate Finance Under Asymmetric Information

TABLE OF CONTENT

ABSTRACT

CORPORATE FINANCE

CORPORATE FINANCE UNDER ASYMMETRIC INFORMATION

CONSEQUENCES OF FINANCIAL DECISIONS WERE ASYMMETRIC INFORMATION EXISTS ARE LISTED AS THUS

ASYMMETRIC INFORMATION BETWEEN INSIDERS AND INVESTORS AND THE CONCOMITANT LEMON PROBLEM.

MARKET BREAKDOWN AND COSTLY SIGNALING

SUMMARY

REFERENCES

ABSTRACT

The specter of decreased economic activities, financial crisis, unbecoming ethical standards have in the recent past and fore going, characterized asymmetric information on corporate finance. The consequences normally have a ricochet effect and can be generally catastrophic to normal economic activities to mention the least. This paper considers scenario’s where information asymmetry was prevalent or may have had its effects play out. The typical investor mindset and the opportunity cost associated with the preferred capital structure of the capitalizing process were mentioned.

A basis for proper appreciation of the concept – Corporate finance under asymmetric information was initiated here, with a detailed explanation of corporate finance and its components, this was succeeded by a summary of scenarios were asymmetric information were prevalent and an intelligent look was also taken at asymmetric information between insiders and investors and the concomitant lemon problem, where the effects were carefully highlighted in a progression to the level of severity - Market breakdown and costly signaling.

The fact that asymmetric information has been widely recognized as bad and generally viewed in a negative light must warrant it being viewed with a high level of seriousness. It is widely known that while lot of effort have been put into stemming the tides of the consequences of asymmetric information, a lot of effort too, have been dedicated to innovation and risk assessment, to capture the interest of investors, who have been affected by the consequences of asymmetric information. These may have formed a veritable platform for a recent paper by Pierre Barbaroux⁵ (2014), that elucidated the rise of innovation and innovative entrepreneurs based on the management of asymmetric information. An attempt has in any case, been made here to suggest efforts at marginalizing the negative impacts of asymmetric information and also remedies at reducing the far reaching impacts on the lenders and the aggregate economic activity in general.

CORPORATE FINANCE

The term corporate finance as the name suggests can be primarily defined as those finance related actions or processes that bother on funding and capital structure and all other efforts geared towards the enhancement of the shareholder value of a company through proper financial planning and implementation of various strategies in capital investment decisions. Professor James P. Dow, Jr² (2009) clearly spelt out in his paper – Basics of Corporate Finance that – ‘‘The essence of business is to raise money from investors to fund projects that will return more money to the investors. To do this, there are three financial questions the company must answer: how much money should they raise, how best to raise the money and then how to return the profits to the investors’’².

Raising capital for business is normally done in two ways – through equity and debt. Using equity to raise funds or capital is realized through issuing stocks and as a result affords the stockholders or owners a stake in the company by way of ownership. In the case of debt, Professor James P. Dow² summed it up as – ‘‘Debt financing is borrowing; investors get a promise of fixed income future payments, but do not have any ownership. Borrowing can be done through a financial intermediary, such as a bank, or directly issuing bonds’’².

The basis of corporate finance in a company is to ensure it is healthy – increased or improved balance sheet values, and this is achieved by the proper management of the interplay of the three very important variables – Equity, Debt and Value, through the employment of strategies that aid investment decision making, then risk and financial planning.

Components of corporate finance are inclusive of the all financial planning activities, risk assessment methods and tools employed, capital budgeting, capital structure management, financial controlling measures put into use in the course of managing the company.

CORPORATE FINANCE UNDER ASYMMETRIC INFORMATION

In corporate finance, the adverse effects of asymmetric information has been an age long problem and fully dictates the goings on in the length and breadth of the money markets, as it pertains to funding and capitalization.

Asymmetric information is best described as a situation where a party to an investment transaction is more informed of the investment than the other. In most cases, the investor is much more grounded is his chosen are of investment or business area. These facts were corroborated by Domantas Skardziukas³ (2010) – ‘‘Often the main problem is that borrowers are more alert of pitfalls of financial contract since they are better aware of the risks involved in a project for which financing is requested. These informational differences are the very underlying cause of adverse selection or what is already known as the lemons problem which was introduced by Akerlof in 1970.’’³. Expert scholars have also expressed similar views and have also gone ahead to associate financial crises and instability to asymmetric information. See Domantus Skardziukas³ (2010), Frederic S. Mishkin⁴ (1991). Pierre Barbaroux⁵ (2014) surprisingly makes a presentation for innovation under asymmetric information and stated that ‘‘Therefore, information asymmetry plays a dual role as it both generates market failures and gives birth to entrepreneurial opportunities’’⁵. Lobna Besbes and Younes Boujelbene⁶ (2014) described a situation where a business owner chooses to capitalize inwardly based on the prevalence of information asymmetry – ‘‘Actually, owing to the prevalence of the information issue, firms ought to opt for promoting the internal funding sources rather than the external ones. Most often, firms with large profits being made usually tend to have recourse and access to the preserved wealth rather than engaging into debt practices to finance their investment projects and strategies. In fact, such a financing mode seems fit well for small, medium and large size firms. In case the firm manager turns out to be simultaneously its major shareholder, as it is often the case for most firms, he would often tend to strengthen and maintain his property and control powers, and therefore would not readily accept the presence of a new shareholder’’⁶. Risk is a concept that is interrelated to information asymmetry. Risk – dearth of reconcilable or confirmed information on a proposed investment and also the fear of the unknown instill a level of apprehension in the financier or lenders and thus leads to a financial decision that will be to the detriment of the investment…that is in a situation where the investment transaction was finalized. Anton Miglo¹¹ (2008), suggested that – ‘‘While a risky or uncertain environment does not represent per se a sufficient condition for asymmetric information, it definitely increases the probability of this situation and its potential extent’’¹¹.

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