Asymmetric Information, Self Selection, and Debt

Abstract

The use of debt has been a continuing research subject after the irrelevance argument made by Miller and Modigliani. Two issues about debt contracts are explored in this paper: why firms use fixed-payment debt contract for external financing if it is Zrrelevant, and why debtholders have no control right. A simple explanation is offered to study the reason of this widely observed arrangement. The explanation relies on the theory of self selection from competing contracts under imperfect information. If the investors do not know the managerial ability of the firm's owner, the use of debt financing is shown to be generally better than the use of external equity financing. We find that the debt contract either drives the equity contract out of the market by revealing the bad managerial ability of the firm's owner, or is used in a self-selection scheme together with external equity contract. In this latter case, the debt contract is preferred by the firm's owner with better managerial ability, and the debtholder receives no control right of the firm. The implication of the model is consistent with the substantial use of debt in the merger and acquisition activities, and the resulting increase of the acquired firm's market value. Whenever a firm is taken over by a better management, debt issues will replace the equity issues. Meanwhile, it also contributes to our understanding of high leverage in capital structure for closely held firms. If the owner believes he/she can manage better, debt issues will be used for external financing.