304 B.E. Eckbo et al.
4.2. Adverse selection and current shareholder takeup
Myers and Majluf (1984)provide the first analytical approach to the equity issue de-
cision under asymmetric information. It is useful to recap the setting of their primary
model:
- The firm’s objective is to maximize the full-information (long-run) value of current
shareholders’ claim on the firm. - The firm knows the true valueaof its assets in place while outside investors know
only the probability distribution overa. - The firm needs to sell equity to raise a cash amount ofIdollars in order to finance a
short-lived investment project with a commonly known net present value ofb. - The equity issue is sold using a simple flotation method: a direct offering to the public
with no mechanism (such as an underwriter) for communication between the issuer
and outside investors, and with no participation in the issue by current shareholders.
A key insight ofMyers and Majluf (1984)is that the cost of selling undervalued stock
may exceedb, causing the undervalued firm to forego the investment project rather than
issue and invest.^24 The cost of this underinvestment drives a demand for more expensive
flotation methods designed to reduce the information asymmetry between the issuer and
outside investors. The cost may also induce the firm to turn to its own shareholders for
additional equity capital. In sum, theMyers and Majluf (1984)setting provide a useful
starting point for thinking about how undervalued firms may use alternative flotation
methods to reduce costly information asymmetry.
For example,Wruck (1989)andHerzel and Smith (1993)suggest that some high-
quality issuers avoid public issues in favor of private placements. In a private placement,
the issuer may directly compensate the investor for costs of due diligence and quality
inspection by selling the issue at a discount relative to the issue’s market price. If the pri-
vate placement investor holds on to the newly created block of shares, there may also be
long-term benefits in terms of increased monitoring of the issuing firm’s management.^25
Firms may also turn to underwriters for quality certification.Baron (1982), Booth and
Smith (1986), Beatty and Ritter (1986), Titman and Trueman (1986)andEckbo and Ma-
sulis (1992)all presume that underwriters have some ability and incentive to evaluate
the extent to which the issuer’s stock may be overpriced, and to avoid selling overpriced
shares to the public. The incentive may emanate from an underwriter’s risk of loss of
reputation, or its risk of legal liability (e.g.,Tinic, 1988; Blackwell, Marr, and Spivey,
1990 ).
(^24) Dybvig and Zender (1991)argue that an appropriately structured managerial compensation contract would
eliminate this underinvestment problem. Similarly,Admati and Pfleiderer (1994)point out that in a firm that
has only investors who hold a fixed fraction of all its securities, management seeks to maximize shareholder
wealth by always investing in positive NPV projects.
(^25) It may also be the case that entrenched managers prefer a private placement. The offering price discount
may be used as compensation to a friendly “white knight” investor for allowing management to maintain
private benefits of control (see alsoZwiebel, 1995). We return to this issue below.