Risk Management and Value Creation in ... - Arabictrader.com

Rationales for Risk Management in Banks 99
difficult for investors to determine the true value of a company’s assets in
general and to evaluate the riskiness of the new investment opportunities 238
in specific, firms are inclined to issue equity when it is overvalued to exploit
their information advantage vis-à-vis (new) shareholders. Because investors
anticipate this behavior, the stock price tends to fall on the announcement
by 3% on average. 239 Due to these indirect costs, firms think that equity is
(very) costly and prefer to avoid financing via the external equity market. 240
Additional agency costs of equity are incurred if equity is issued when a
firm’s outstanding debt is sufficiently risky. As discussed previously, this
redistributes wealth from shareholders to bond holders. 241
The Underinvestment Problem Even though these signaling costs are (almost)
not observable for the issuance of debt, 242 there are the previously mentioned
(indirect) agency costs of potential future bankruptcy 243 associated
with the issuance of debt. 244 However, in this context, there is another dimension
to the already discussed underinvestment problem: Due to the
shortage of available (internal) funds (and not due to agency problems),
investment is foregone and its associated positive NPV is lost, making it a
direct cost. As we will discuss in more detail, this kind of underinvestment
can occur even without excessive leverage (i.e., represented by the bottomup
arrow in Figure 3.2).
The Costs of Issuance Additionally, there are direct and discrete transaction
costs associated with obtaining external funds 245 that can be, for example,
on the order of 5% of the value of the new equity. 246
Froot and Stein 247 show that the more difficult (and hence the more
238 See Allen and Santomero (1996), p. 16.
239 See, for example, Asquith and Mullins (1986). Stulz (2000), p. 4-40, estimates the
value of the existing equity falls by about 2.5%. Since the value of the existing equity
is decreased, this is an agency cost of equity.
240 See Froot et al. (1994), p. 94. Also see Miller (1995), p. 484, who states that
equity is expensive for banks to raise.
241 Also see, for example, Miller (1995), p. 484, who describes this problem in the
context of banks.
242 See, for example, Eckbo (1986).
243 See Allen and Santomero (1996), p. 16.
244 For highly levered firms, additional debt financing requires a significant premium
to compensate lenders for the costs of financial distress.
245 See, for example, Allen and Santomero (1996), p. 16, and Mason (1995), p. 32.
The size of these transaction costs is described, for example, in Brealey and Myers
(1991), Chapter 15.
246 See Stulz (2000), p. 4-40.
247 See Froot and Stein (1998a).