JEAN-PAUL PAQUIN, ANNICK LAMBERT AND ALAIN CHARBONNEAU 283CAPM efficient market completely ignores the fact that the real economy is
neither transparent nor frictionless.
Indeed, the legal system establishes a clear distinction as to the roles,
the rights and obligations of debtholders, shareholders and managers. Such
legal constraints imply informational asymmetries which explain why the
financing of risky investment projects, even those profitable, is not easily
obtained. The difficulty to finance risky investment projects is even exac-
erbated under conditions of financial distress as the total risk of the firm
rapidly becomes the fundamental and dividing issue between the main
stakeholders.
For instance, when the probability of financial distress or bankruptcy
of a firm is not trivial, and, consequently, when its equity value is low,
then funds provided by shareholders serve essentially to make safer the
debtholders’ risky outstanding debt, in addition to providing at their own
expense the rate of return that the new shareholders will be seeking (Myers,
1977). We may also add that when a firm’s probability of bankruptcy is
significant, it becomes quite rational for shareholders to increase the total
risk of the firm by accepting very risky investment projects that might
very well rescue the value of their equity even if this implies increased
risks at the expense of debtholders. The shareholders risk to lose little
and to gain much for in the worst case scenario shares would become
worthless anyway. The shareholders would be actually transferring part
of their total risk to the debtholders and thus maximizing the wealth
of shareholders instead of the value of the firm (Jensen and Meckling,
1976).
Also, as a firm’s probability of financial distress increases, investors might
find it evermore difficult, due to asymmetrical information, to distinguish
sound projects that might increase the shareholders’ value from pet projects
that aim essentially at increasing the size of the firm and consequently the
powerbase, perquisites consumption, salaries and stock options of top man-
agers. As a consequence of informational asymmetries, valuable projects
might be foregone in the process of capital budgeting given the cash shortage
experienced by a firm under financial distress (Stulz, 1999).
The proposition according to which managers should be risk neutral and
should be using the CAPM certainty equivalent decision rule is therefore not
applicable when a firm experiences financial distress. That such a certainty
equivalent decision rule has been proposed and used by academics for the
last 40 years is understandable given that under the Modigliani–Miller per-
fect market paradigm it is always feasible to finance any profitable project
even when a firm is close to financial distress. It should surprise nobody
to learn that the CAPM equilibrium share price equation exposes itself to
large values of probability of loss (Laughhunn and Sprecher, 1977). Now,
considering that the CAPM assumes no default risk, it is quite logical that
such an efficient market would set security prices without regard to the risk