Problem Set 5
Thomas Noe
Myers/Majluf and the pecking order
1. Consider the example of the Myers/Majulf problem in Lecture 3. In this example, we
found one equilibrium. Suppose that, in this example the firm has o = 5 shares outstand-
ing, (before it issues any new equity).
a. How many new shares, n, will the firm issue when the manager knows the state
j = B?
b. What will the price of the shares equal after the manager announces that the firm is
going to undertake the project and issue equity?
c. What will the price of the shares equal if the manager announces that the firm will
not issue equity and therefore reject the project?
d. What will be the price of the shares right before the manager announces his de-
cision?
2. Consider the example of a Myers and Majluf equilibrium that we worked out in the
lecture. As in the lecture, assume that I = 1 and that p = 1/2. Change the other parameters
of the example as follows: aG = 3/2, aB = 1, bG = bB = 1/8. Use these numbers to answer
the following questions:
a. Does an equilibrium exist in which the manager issues equity and invests both when
the state is G and when the state is B?
b. Does an equilibrium exist in which the manager issues equity and invests when the
state is B but not when the state is G?
c. Does an equilibrium exist in which the manager issues equity and invests when the
state is G but not when the state is B?
d. Does an equilibrium exist in which the manager never issues equity and invests?
Empirical predictions of capital structure theory
3. Consider the problem of interpreting the results from test of capital structure models.
In each part of the question, I will provide a hypothetical result from an empirical test.
For each of these results. Interpret the result as being probably consistent or probably
inconsistent with one of the four capital structure theories we have discussed: the tradeoff
theory, the pecking order theory, incomplete contracting theory, market timing theory.
Please answer each part in 50 words or less.
a. Suppose your data shows that firm that have more tangible assets (e.g. land, air-
planes) issue more debt than firms with less tangible assets (e.g. software programs,
patents).
b. Suppose your data shows that firms issue equity only in periods where price of
stocks is very high relative to the book value of stocks.
c. Suppose that your data shows that firms almost never issue equity when they have
lots of cash on their balance sheets.
d. Suppose your data shows that firms with high volatility earning have smaller lever-
age ratios than firms with low volatility earnings.
4. Depreciation, like interest payments is a tax shield, i.e., a charge that firms can deduct
from their taxable earnings. Depreciation represents the decline the value of the firms
capital stock (e.g. equipment) caused by the passage of time. From the perspective of
trade-off (tax/financial distress) theory, everything else held equal, should firms with a
lot of deprecation tax shields have higher or lower leverage ratios? You might want to
take a look at
DeAngelo, H., & Masulis, R. W. (1980). Optimal capital structure under cor-
porate and personal taxation. Journal of Financial Economics, 8(1), 3-29.
but you might be able to figure out the answer without looking at their paper. Please
answer this question in 100 words or less.
Problem Set 5 21st November, 2020 2/2