Information ratings and capital structure
Introduction
Since the seminal work of Modigliani and Miller's (1958) irrelevancy proposition on capital structure in a market without frictions, there has been ongoing research to understand how market imperfections affect a firm's financing decisions. One source of market frictions is the information asymmetry between managers and investors about firm value. Myers (1984) and Myers and Majluf (1984) argue that as the manager know more about their firms' true values than investors, they tend to exhibit a particular preference for their financing choices. In particular, the manager follows the pecking order of internal capital over debt, and external equity as a last resort to minimize adverse selection costs.
To date, the empirical findings on the pecking order model are mixed. While Shyam-Sunder and Myers (1999) show that firms' financing priorities are consistent with the hypothesis, Fama and French (2005) find that managers across various firm size frequently issue and retire equity. To accommodate alternative theories in explaining a firm's behavior on financing decisions, Bharath et al. (2009), Lemmon and Zender (2010), and Rapp et al. (2014) expand the scope of empirical tests with financial slack and flexibility for investment opportunities and costs of financial distress. However, Jung et al. (1996) and Leary and Roberts (2010) continue to cast doubt on the robustness of the prescribed order. They suggest that agency conflicts are better equipped to explain the observed debt and equity issuances than information asymmetry.
Given that information asymmetry is hypothesized to play an important role in a firm's financing choices, one key challenge in testing the model validity rests with how well the information barrier between the manager and investors can be estimated. In this study, we take advantage of a unique information rating score on the amount of information disclosed by firms to examine the role of information asymmetry. Based on 114 indicators on information disclosure over five different sub-categories, the Securities and Futures Institute (SFI) in Taiwan compiles disclosed information of each firm and assigns an information rating accordingly. These five sub-categories include information related to regulatory compliance, information timeliness, forward-looking information, and information reported in annual reports and in company websites. Ranging from C- to A++, a firm that receives a C- (A++) rating is said to have the lowest (highest) corporate transparency or exhibit the highest (lowest) asymmetric information. Appendix A lists each of the 114 criteria.
Similar to a change in credit rating on the credit worthiness of a firm, an upgrade (downgrade) of a firm's information rating indicates that information asymmetry between the firm and investors is lower (higher) than before. A change in information rating is thus more definitive, intuitive, and meaningful than proxies that carry multi-faceted interpretations found in previous studies. For example, Autore et al. (2014) use volatility of stock returns, firm size, institutional ownership, and the proportion of independent directors as proxies for information asymmetry. However, these proxies are also used as measures for firm risk and incentive conflicts. While a large firm is related to lower asymmetric information, it also indicates higher agency costs. Meanwhile, a firm with high proportion of institutional ownership and independent directors has lower information asymmetry, but it may also reflect lower agency cost. Other more dynamic proxies, such as the level of analyst coverage and dispersion of analysts' forecasts, are highly correlated with these proxies and therefore subject to different interpretations.
More sophisticated proxies related to adverse selection based on the market microstructure framework have been used to extract information asymmetry. For example, effective bid-ask spread (George et al., 1991), probability of informed trading (PIN, Easley et al., 1996), and price impact measure (Amihud, 2002) were developed to measure the information from trading. Using a composite index approach, Bharath et al. (2009) estimate the first principal component of four adverse selection and three market liquidity measures for measuring information asymmetry. In a similar vein, Andres et al. (2014) compile an information asymmetry index based on six liquidity measures that capture trading activity, trading costs, and the price impact of order flow. While such approaches may increase the accuracy of the measurement, they continue to be indirect measures. More importantly, they may be subject to measurement errors due to “non-informational” liquidity components in the proxies.
Overall, we find that information asymmetry is important in explaining financing decisions. In particular, the level and the change of information ratings are negatively related to net debt. A firm with higher information rating tends to exhibit lower leverage as the adverse selection cost of issuing equity is likely to be less. Our results are therefore consistent with pecking order theory. Our findings also complement Chung et al. (2013) who show that capital structure of a firm in the oil industry has little influence on its survival probability. They suggest that firm performance tends to be driven largely by its business fundamentals.
In examining the role of information asymmetry, we also broaden the scope of the study by including incentive conflicts in the sense of Jensen and Meckling (1976) and the agreement theory of Dittmar and Thakor (2007). Accordingly, a firm with higher incentive conflicts is more likely to issue debt than equity. A firm with lower agreement between the manager and investors on managerial decisions and stock prices also tends to choose debt over equity to reduce adverse selection costs. We find that information ratings continue to be influential in a firm's capital structure decisions independent of these alternative theories. However, our results also suggest that incentive conflicts and the agreement theory can affect a firm's financing mix.
Our findings highlight the complementary role of information transparency in a climate of stronger governance practices around the world initiated by Sarbanes–Oxley Act. As summarized by Kim and Lu (2013) on the recent corporate governance reforms in 26 advanced and emerging economies, much of the focus has been on improving governance mechanisms.
Nevertheless, Healy and Palepu (2001) point out that there also appears to be a convergence in information disclosure practices driven by the globalization of capital markets as institutional investors are looking for diversification and corporations are seeking capital at the best possible terms. The introduction and increasing adoption of international financial reporting standards (IFRS) to harmonize financial disclosures across countries facilitate such process. For example, Singapore introduces a legislation in 2001 to increase the quality and broaden the scope of information disclosure. China has adopted IFRS since 2001 as the basis for enhancing the quality and transparency of financial information. In developed countries, France and Germany encourage firms to disclose share ownership for as low as 5% and 3% of total shares respectively. Our results based on the ratings of multi-dimensional information disclosure practices in Taiwan may therefore suggest similar financing behaviors of firms in countries of comparable information settings.
The remainder of the paper is organized as follows. Section 2 discusses the background and the development of the information rating framework. Section 3 compares the measures of information asymmetry in the finance and accounting literature with those established by the SFI. Section 4 describes the data and research design. The empirical results are reported in Section 5, and the last section concludes the paper.
Section snippets
Brief history of information disclosure and ratings in Taiwan
The Company Law in Taiwan was first established in 1919 and the Security Law in 1968. They defined the rights and responsibilities of firms to protect the interests of shareholders and debt holders. However, investor protection based on these laws is either inadequate or ineffective to meet the welfare of shareholders and debt holders. La Porta et al. (1998) report that the efficiency of the judicial system and corruption in Taiwan are poorly ranked among countries with the same German legal
Proxies for information asymmetry in the finance literature
The proxies for information asymmetry in the extant finance literature can be categorized into three groups. The first group is based on firm characteristics such as firm size, market-to-book equity, growth opportunities, or intangible assets (e.g. Titman and Wessels, 1988, Baker and Wurgler, 2002: Frank and Goyal, 2003, Lemmon and Zender, 2010). Large firms are often viewed with lower information asymmetry, while firms with high market-to-book equity are characterized by high growth
Research design
We follow the standard approach of Shyam-Sunder and Myers (1999) to test the pecking order model by regressing net debt issuance, ΔDi,t, on the financing deficit, DEFi,t, as follows:where ΔDi,t is the long-term debt issuance minus long-term debt reduction for firm i at time t, and DEFi,t is defined by the accounting cash flow identity,where DIVi,t are dividends and share repurchases, CEXi,t are capital expenditures, ΔWCi,t is the net change
The pecking order model test
To test the pecking order model, we begin by estimating the relationship between net debt issuance and financing deficit according to Eq. (1). Models 1 and 2 of Table 4 show that the relationship is significantly positive (β = 0.142 and 0.148) with or without industry and year fixed effects. The preliminary results are thus consistent with the modified version of the pecking order model in which β lies between 0 and 1 (see Bharath et al., 2009, Lemmon and Zender, 2010, Myers and Majluf, 1984).
We
Conclusion
Using a unique dataset of information scores based on 114 measures of corporate transparency across five dimensions of information disclosure, we find that a firm with higher information ratings is related to lower net debt. Furthermore, an upgrade in information ratings leads to a reduction in firm leverage. These results are consistent with the observed pecking order behavior as lower information barrier reduces a firm's adverse selection costs.
The negative relationship between firm leverage
Acknowledgments
We are grateful to an anonymous referee and especially Jeffry Netter (the editor) for their helpful comments.
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