CLASS NOTES ON CORPORATE FINANCE4.pdf

TOPIC 4: ASYMMETRIC INFORMATION MODELS OF CAPITAL STRUCTURE
1. Introduction
The recent economic literature has emphasized a lot the importance of asymmetric information to our
understanding of a wide range of issues varying from taxation and regulation of firm to optimal nonlinear
prices and insurance contracts. These types of models have also shown to be very powerful in the context
of corporate finance since they can explain why firms rely on one type of financing rather than another
and why firms may have preferences over different ways of paying out profits to shareholders. In this
chapter we shall review some of the classic applications of this approach to the capital structure literature.
2. The lemons problem
One of the most important contributions to the literature on asymmetric information is Akerlof’s paper
"The Market for Lemons: Qualitative Uncertainty and the Market Mechanism," (., 1970). The main
point in this paper is that the presence of asymmetric information creates an adverse selection problem:
if consumers cannot tell the quality of a product and are willing to pay only an average price for it, then
this price is more attractive for sellers who have bad products than to seller who have good products
(hence the term adverse selection). Consequently, more bad products (., lemons) will be offered than
good products. Now, if consumers are rational, they should anticipate this adverse selection and expect
that at any given price, a randomly chosen product is more likely to be a lemon than a good product. Of
course, these expectations imply a lower willingness to pay for products and so the proportion of good
products that is actually offered falls further. Eventually, this process may lead to plete break down
of the market.
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This lemons idea is also important for corporate finance: if investors cannot observe the value of
firms before they buy them then they would be willing to pay only an average price for the equity o