DISSERTATION PROPOSAL

The Choice Between Debt And Equity

Abstract

This paper will analyze debt-equity choice for financing a two-stage investment when a firm's insiders have private information about the firm's expected earnings. When private information is one-dimensional (for example when short-term earnings are common knowledge while long-term earnings are private information) a separating equilibrium does not exist. When private information is two-dimensional a separating equilibrium may exist where firms with a higher rate of earnings growth issue debt and firms with a lower rate of earnings growth issue equity. This will provides new insights into the issue of different kinds of securities by different types of firms under asymmetric information as well as the link between debt-equity choice and operating performance.

Table of Content

Abstractii

CHAPTER 1: INTRODUCTION1

Outline of the Study1

Problem Statement1

Rationale1

Aims and Objectives1

Significance2

Research Question2

Theoretical Frame work3

Limitation of the Study3

Ethical Concerns4

CHAPTER 2: LITERATURE REVIEW5

CHAPTER 3: METHODOLOGY7

Research Design7

Data Collection Method7

References8

CHAPTER 1: INTRODUCTION

Outline of the Study

Most existing literature deals with one-dimensional asymmetric information-most frequently concerning the value of the firm. In this approach the solution is typically a pooling equilibrium where the “bad” type (one with low value) mimics the “good” type (one with high value) by issuing the same kind of securities. A “second effort” (additional assumptions) is needed to explain why firms issue securities that are not a part of the equilibrium.

Problem Statement

The paper will analyzes debt-equity choice when asymmetric information exists between firms' insiders and market participants regarding future earnings.

Rationale

The main engine driving the results of the paper is that a separating equilibrium exists where firms with a low rate of earnings growth issue equity. This equilibrium implies that firms issuing equity have better operating performance at the moment of issue or in the near future after issue, and that these firms have lower operating performance in the long run. The long run operating underperformance of equity issuing firms has been documented in several studies.

Aims and Objectives

We will analyze a two-stage investment-financing model where managers representing initial shareholders have the choice between debt (short- and long-term) and equity. When only the total earnings are private information, and the timing of earnings is common knowledge, the equilibrium is pooling. However, when both the value of the firm and the timing of earnings is management's private information a separating equilibrium may exist.

Significance

We will show that the value of shares depends on the firm's total value and not on the timing of earnings or on the rate of earnings growth; the value of long-term debt relies on the expected performance in the long term and the value of short-term debt depends primarily on the expected performance in the short term. If a firm with a high rate of earnings growth issues long-term debt it will be mimicked because of high expected long-term performance which implies a high value of long-term debt, respectively. The same holds if the firm issues equity. Other firms may find it attractive to mimic this strategy not necessarily because of the high value of equity but because of the high value of future claims ...