NBER WORKING PAPER SERIESSERIES

INFORMATIONAL IMPERFECTIONSON ThEThE CAPITAL MARKET ANDAND MACRO—ECONOMIC FLUCTUATIONSFLUCTUPT IONS

Bruce Greenwald Joseph E. Stiglitz

AndrewWeiss

Working Paper No. 13351335

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts AvenueAvenue Cambridge, MA 02138 April 198)419814

The research reported here is part ofof thethe NBER1sNBER1s researchresearch programprogram in Taxation. AnyAny opinionsopinions expressedexpressed areare those of the authors andand not those of the National Bureau of EconomicEconomic Research.Research. NBER Working Paper ##1335 April 1984

Informational Imperfections onon thethe Capital Market and Macro—Economic FluctuationsFluctuations

ABSTRACT

This paper describes the role that informational imperfections in

capital markets areare likelylikely toto playplay inin businessbusiness cycles. cycles. It thenthen developesdevelopes

a simple illustrative model of the impact of adverse selection in the equity

market and the way in which this may lead to large fluctuations in the ef-

fective cost of capital in response toto relativelyrelatively smallsmall demanddemand shocks.shocks.

The model also derives an expression forfor thethe costcost ofof equityequity capitalcapital inin thethe

presence of adverse selection and provides informational explanations for several widely observed macro—economic phenomena.phenomena.

Bruce Greenwald Joseph E. Stiglitz Andrew Weiss Harvard Business School Harvard Business School Princeton University , MAMA 0216302163 Princeton, NJNJ 0854408544 New York, NYNY 1002410024 INFORMATIONALINFORMATIONAL IMPERFECTIONS IMPERFECTIONSIN IN THE CAPITALCAPITALMARKET

ANDMACRO—ECONOMIC FLUCTUATIONS

Traditional neoclassical theorytheory has one clear,clear, unambiguous,unambiguous, and and verif verifi- i— able prediction:prediction: allall factors factors which which havehave a positivepositive priceprice areare fullyfully utilized. In recent years, there have been several responses to the apparent inconsistency between the predictions ofof neoclassicalneoclassical theorytheory andand whatwhat hashas Inin factfact beenbeen observed.observed.

The firstfirst isis toto denydeny thethe empirical empirical observations: observations: thethe 25%25% ofof thethe populationpopulation thatthat were unemployed in in the the Great Great Depression, Depression, let let alone thethe 10%10% ofof the populationpopulation thatthat were unemployed inin thethe Reagan Reagan Recession Recession were were not not involuntarily involuntarily unemployed. unemployed. ThisThis seems to us, at best, semanticsemantic quibbling,quibbling, andand wewe shallshall havehave nothingnothing furtherfurther toto saysay here concerning thatthat view.view. TheThe secondsecond is to argue, without muchmuch justification,justification, that there are two regimes; traditional neoclassical theory applies in "normal times."tiuies." ItIt seemsseems moremore plausibleplausible toto usus thatthat thethe marketmarket failures represented byby thethe

Great Depression areare alwaysalways presentpresent inin thethe economy,economy, butbut difficultdifficult toto detect;detect; itit isis only when they they reach reach the the proportionsproportions thatthat theythey dodo periodicallyperiodically that that we we cancan nono longer ignore them.

A third approach is to modify the standardstandard theory,theory, toto assumeassume thatthat wageswages and pricesprices areare fixed.fixed. ThisThis approachapproach hashas rightfullyrightfully been criticized both for its ad hocery and its inconsistency——whyinconsistency——why shouldshould rationalrational profitprofit maximizingmaximizing firms,firms, obeying all of the other neoclassical assumptions, not cut their prices in the face of excess demand.

This paperpaper isis partpart ofof anan attemptattempt toto developdevelopa a consistent consistent set set of ofmicro— micro— foundations for macro—,macro—economics, based based on on imperfect imperfect information. information. WeWe focusfocus herehere onon the capitalcapital market.market. KeynesKeynes arguedargued thatthat thethe sharpsharp drop in investment and the failure of the interest raterate toto fallfall sufficientlysufficiently toto restorerestore investmentinvestment toto aa normal level was aa centralcentral partpart ofof thethe descriptiondescription ofof anyany businessbusiness cycle. cycle. Keynes'Keynes' analysis ofof investmentinvestment was,was, however,however, basically basically a aneoclassical neoclassical analysis: analysis: itit waswas —2—

the failure of the real interest raterate (the(the long—termlong—term bondbond rate)rate) toto fallfall suffi-suffi- ciently that was thethe sourcesource ofof thethe problem.problem.

Three aspectsaspects ofof thisthis analysisanalysis havehave alwaysalways been been troubling: troubling: first,

Keynes' explanation of the failure of real interest rates to fall, the liquidity trap, is notnot persuasive.persuasive. Second,Second, surveyssurveys suggest that firms' investmentinvestment behaviorbehavior is not particularly sensitivesensitive toto the the interest interest rate rate that that they they pay. pay.Third, Third, itit hashas always seemed difficult to account forfor thethe magnitudemagnitude ofof thethe fluctuationsfluctuations inin investment in terms of the observed magnitudesmagnitudes ofof variationsvariations inin realreal interestinterest rates, outputs, wages, and prices, unlessunless firmsfirms areare veryvery riskrisk averse;averse; andand itit Isis hard to reconcile highhigh degreesdegrees ofof riskrisk aversionaversion onon thethe partpart ofof firmsfirms withwith well—functioning (neoclassical) capital markets.markets.

This paper is based on the hypothesis thatthat Keynes'Keynes' judgmentjudgment concerningconcerning that the importance ofof fluctuationsfluctuations inin investmentinvestment isis correct,correct, butbut thatthat hehe Incor-Incor- rectly analyzedanalyzed thethe determinantsdeterminants ofof investment investment behavior. behavior. WeWe argueargue that:that:

1. ManyMany firmsfirms faceface creditcredit constraints;constraints; thus it is the availabilityavailability ofof credit, not the price whichwhich theythey havehave toto pay,pay, whichwhich restrictsrestricts theirtheir investment,investment, oror when it is working capital which is curtailed, which limits their production.

2. FirmsFirms thatthat areare notnot creditcredit constrainedconstrained maymay stillstill face an increase inin the effective cost of capital, which induces them to reduce their investment.

(The increase in thethe effectiveeffective costcost ofof capitalcapital hashas furtherfurther effects,effects, e.g.,e.g., onon thethe pricing decisions of firms.)

I. TheThe DebtDebt Market

The main informational problemproblem facingfacing banksbanks isis thatthat theythey dodo notnot knowknow howhow the money theythey lendlend isis beingbeing invested. invested. Stiglitz—Weiss (1981,1983)(1981,1983) showedshowed thatthat anan increase in the interest raterate chargedcharged borrowersborrowers will,will, inin general,general, increaseincrease thethe average riskinessriskiness ofof thethe projects projects a abank bank is is financing. financing. ThisThis isis eithereither becausebecause borrowers switch toto riskierriskier projectsprojects oror becausebecause safersafer projectsprojects becomebecome relativelyrelatively —3—

less attractive andand soso investorsinvestors withwith safe safe projects projects do do not not apply apply for for loans. loans. TheThe

effect on the riskiness of loans may outweighoutweigh thethe directdirect gaingain toto thethe bankbank fromfrom

increasing itsits interestinterest rate. rate. Thus, the bank's profitprofit maymay bebe maximizedmaximized atat an interest rate at which there is an excessexcess demanddemand forfor loanableloanable funds.funds.

This kind of phenomenon (an interior price maximum andand rationing,rationing, whichwhich may also occur in thethe laborlabor market)market) helpshelps toto explainexplain businessbusiness cyclescycles inin threethree ways. First, and and mostmost obviously, it it providesprovides aa rationalerationale for thethe persistencepersistence of non—market—clearing. Second,Second, it may may accountaccount forfor variationsvariations in a firm's cost ofof

capital whichwhich areare unrelatedunrelated toto observedobserved variations variations in in interest interest rates. rates. TheThe likeli-likeli- hood and severity ofof creditcredit rationingrationing maymay wellwell increaseincrease inin aa recessionrecession withoutwithout necessarily anyany concurrentconcurrent changechange in in interest interest rates. rates. AnAn increaseincrease inin creditcredit rationing might be expected both because ofof greatergreater uncertaintyuncertainty concerningconcerning thethe prospects of firms and an increase in the dead—weight loss associated with bank- ruptcy. Third,Third, information—basedinformation—based rationingrationing models can explainexplain howhow stabilizationstabilization policy isis likelylikely toto work.work. ForFor example,example, monetary policiespolicies whichwhich seekseek toto increaseincrease investment byby loweringlowering interestinterest ratesrates will will not not have have the the desired desired effect: effect: therethere isis no shortage ofof willingwilling borrowers.borrowers. However, policies thatthat IncreaseIncrease thethe avail-avail- ability of loanableloanable fundsfunds willwill increaseincrease investment,investment, eveneven though though they they maymay notnot affect the level of interest rates at all.

There are twotwo objectionsobjections toto ourour creditcredit rationingrationing theorytheoryas as anan explana-explana- tion ofof thethe cyclicalcyclical fluctuationsfluctuations in in investment. investment. First,First, whywhy don'tdon't firmsfirms thatthat faceface credit constraints fromfrom banksbanks attemptattempt toto raiseraise capitalcapital byby somesome other othermeans, means, inin particular, byby issuingissuing newnew equity. equity. AndAnd second, manymany firmsfirms thatthat do not appear toto be credit constrained also seem to reducereduce theirtheir investmentinvestment dramatically.dramatically.

Thus, a necessary complement to the theorytheory ofof creditcredit rationingrationing isis aa theory ofof informationalinformational imperfections imperfections in in equity equity markets. markets.This This we we present present Inin thethe next two sections. —4—

II. Equity Markets A firm'sfirm's abilityability toto raiseraise equityequity capitalcapital isis limitedlimited by by informational informational imperfectionsimperfections fortwo basicbasic reasons.reasons. First, incentive problems maymay intensifyintensify whenwhen a firm is equityequity financed.financed. Managers,Managers, who who receive receive oniy only a asmall small fraction fraction ofof anyany additional profit,profit, areare likelylikely toto putput forthforth less—than—optimalless—than—optimal amounts amounts ofof effort.effort.

Imposing large bankruptcy costs on managersmanagers maymay actact asas aa spurspur totoadded effort and the value of thesethese incentivesincentives isis reducedreduced byby additionaladditional equity equity finance. finance. DebtDebt financing alsoalso allowsallows managersmanagers lessless flexibilityflexibility inin disposingdisposing ofof netnet incomeincome than equity doesdoes, Thus,Thus, equityequity fundsfunds maymay reducereduce the value of a firmfirm byby allowingallowing moremore

"profit" toto bebe diverteddiverted toto thethe privateprivate uses uses of of the the firm's firm's managers. managers. Finally,Finally, lenders havehave thethe powerpower toto discipline discipline tnanagers managers by by withdrawing withdrawingtheir their funds. funds. ThisThis isis a sanction which cancan bebe imposedimposed piecemealpiecemeal andand may,may, therefore,therefore, be more effective than share voting to which majority rule applies.1applies.1

Second, signalling effects may restrict a firm's access to equity markets. ManagersManagers ofof firms,firms, which theythey knowknow toto bebe "good,""good," maymay bebe willingwilling toto assume greatergreater debtdebt burdens.burdens. Both the absolute level of bankruptcy riskrisk andand anyany incremental increase duedue toto addedadded debtdebt willwill bebe smallersmaller forfor "good""good" thanthan forfor "bad""bad"

firms. GreaterGreater reliancereliance on debt by "good" firmsfirms means that that equity willwill predomi- predomi- nantly bebe soldsold by inferiorinferior onesones (see(see Ross Ross (1977)). (1977)). Thus,Thus, attemptingattempting toto sellsell

equity may conveyconvey aa strongstrong negativenegative signalsignal aboutabout aa firm'sfirm's qualityquality and reducereduce its its market value accordingly.

The model presented inin thisthis paperpaper analyzesanalyzes thethe cyclicalcyclical costcost ofof capitalcapital

implications ofof thethe signallingsignalling processprocess justjust describeddescribed as as an an exampleexample ofof thethe macro-macro—

economic impactimpact ofof thethe manymany limitationslimitations on on equity equity issue issue which which are arenoted noted above. above. ItIt

provides anan explanationexplanation forfor large,large, butbut notnot directlydirectly observable, observable, variationsvariations inin thethe

marginal cost of capitalcapital (to(to bebe distinguisheddistinguished fromfrom thethe averageaverage cost cost ofof capitalcapital

measured forfor exampleexample byby Tobin'sTobin's q)q) whichwhich cancan accountaccount for for many many of of the thevariations variations inin

investment whichwhich areare commonlycommonly associatedassociated with with business business cycles. cycles. TheThe negativenegative —5—

signal associated with issuing equityequity means that the cost of equity is prohibitive for many firms.firms. Thus,Thus, thethe effectiveeffective marginal cost of capitalcapital isis thethe marginalmarginal costcost of debt which consists of the monetary cost of interest plus the marginal increase in expected bankruptcybankruptcy costcost associated associated with with additional additional debt. debt.The The latter latter bankruptcybankruptcy cost will increase asas aa firmfirm facesfaces unexpectedlyunexpectedly adverseadverse economiceconomic conditionsconditions andand may do so dramatically.dramatically. Moreover,Moreover, it is likely that thethe adverseadverse signalsignal associatedassociated with issuing equity will intensify and place equity finance even further out of reach in just these circumstances.

III. AA SimpleSimple Model

In this section,section, wewe constructconstruct aa simplesimple model model which which enables enablesus us explicitly explicitly to determine which investors will make use of the equity market and which of the debt market, and whichwhich enablesenables usus toto calculatecalculate thethe effectiveeffective marginalmarginal costcost ofof capital. BecauseBecause wewe wishwish toto focusfocus onon the equity market, wewe assumeassume bankersbankers cancan perfectly discriminatediscriminate among among borrowersborrowers — —indeed,indeed,the function of banks isis toto differentiate potentialpotential borrowersborrowers intointo theirtheir appropriateappropriate riskrisk classesclasses ——butthat the equityequity marketmarket treatstreats allall thosethose seekingseeking equityequity thethe seine.same. (Thus, while

Stiglitz—Weiss (1981) were concerned withwith imperfectimperfect informationinformation inin thethe creditcredit market, we are concernedconcerned herehere withwith imperfectimperfect information information in in the the equity equity market. market. InIn a sequel, wewe investigateinvestigate aa moremore general general model model incorporating incorporating both.) both.) WeWe makemake thethe following assumptions:

(Al) Each firm is characterized by a net cash flow,8 (Al) Each firm is characterized by a net cash flow,8,, fromexisting operations

and a set of new investmentinvestment opportunitiesopportunities whosewhose returnreturn isis £Q(K),£Q(K), wherewhere CCisisa

r.v., E(C) =1,Var(C) = and K isis thethe levellevel ofof investment.2investment.2 For exposi—exposi—

tional reasons, although firmsfirms areare assumedassumed toto havehave differentdifferent levelslevels ofof O,Q(')O,Q(') is assumed toto bebe thethe samesame for for all all firms. firms. TheThe parameterparameter 00 describesdescribes thethe

"quality" oror "value""value" ofof aa particularparticular firm firm andandhas has a a distribution distribution N(e) N(e) across across 3 firms. —6—

At the beginning of the period firms announce their equity sales In—in— tentions andand V,V, eacheach firm'sfirm's marketmarket value, value, adjusts adjusts accordingly. accordingly. FirmsFirms thenthen sellsell

(or do not sell) equity, determine thethe levellevel investmentinvestment andand financefinance anyany uncovereduncovered balance withwith debt.debt. AtAt thethe endend ofof thethe period,period, thethe resultsresults ofof newnew investmentinvestment are determined, somesome firmsfirms gogo bankrupt,bankrupt, andand thethe values values of of6 6are are revealedrevealed forfor thethe remaining firms.firms. TheThe terminalterminal valuevalue ofof each each firm'sfirms equityequity isis determined determined basedbased onon its observed value of 0.0. Managers' compensationcompensation dependsdepends onon currentcurrent marketmarket valuevalue and the share of terminal market valuevalue heldheld byby originaloriginal shareholders,shareholders, ifif thethe firmfirm does notnot gogo bankrupt.bankrupt. InIn thethe eventevent ofof bankruptcybankruptcy managersmanagers bearbear aa knownknown fixed cost.

Assuming risk neutrality, the firm actsacts asas ifif itit maximizes,maximizes,

V T == mV0+(1—rn)(1—m)(ve)(Q(K) —b(1+R))— (1) mV0 (ve6 — cPB

where,

b == K—aK—eElevelof new borrowing,

R Expected return on debt,debt,

c E Cost which "bankruptcy""bankruptcy" imposesimposes on on a afirm's firm's illanagers, managers,

Probability of "bankruptcy,"

m EE Factordescribing thethe weightweight thatthat firmsfirms placeplace onon theirtheir initial as opposed to their terminal market value.

(A2) "Bankruptcy" occursoccurs if,if,

e + eQ(K)Q(K)<<(1+R)b,(1+R)b, (2)

where RR E Contractual raterate ofof interestinterest onon aa firm'sfirm's debtdebt ° >R.

(A3) Lenders are fullyfully informed,informed, riskrisk neutralneutral andand requirerequire anan expectedexpected returnreturn R,R,

+ dF(c), (1+R) == (l+R)(l_PB)(l+R)(l_PB)+fo061fo01dF(c), (3) —7—

= — the value of e below which "bankruptcy" where = [(1+R0)b[(1+R0)b eJ/Q(K) the value of e below which "bankruptcy" occurs.

(A4) EquityEquity investorsinvestors areare risk risk neutral neutral and and require require an an expected expected return return R. R. TheyThey

observe onlyonly thethe levellevel ofof aa firm'sfirm's equityequity sales sales in in determining determining V0. V0. FirmsFirms

selling equityequity sellsell aa couunoncommon dollar amount e.e.

The information structure of the model maymay appearappear restrictive,restrictive, butbut inin fact is quitequite general.general. AllowingAllowing equityequity investors to observeobserve onlyonly thethe levellevel ofof equity sales is a matter of interpreting thethe modelmodel asas applyingapplying toto aa setset ofof firmsfirms whose other observableobservable characteristicscharacteristics are are identical. identical.The The analysisanalysis needneed onlyonly bebe replicated for each such class of firms to cover the full firm population.4'5

A firm'sfirm's equityequity sale decision rule can be characterized byby examiningexamining thethe function,

H(0)H(O) E TD(O)TD(O) —— TE(O), where,

TD - +Q(KD) — KD(l+R))— TD E mVD + +(1-in)(O (1—mn)(0 + Q(KD) —KD(1+R))—cP E Initial value of firms selling no equity,

E OptimalOptimal levellevel ofof investmentinvestment forfor a non—equity selling firm ofof quality 00 (the(the 0 0argument argument hashas beenbeen supressed),

Levelof bankruptcy risk impliedimplied byby thethe optimaloptimal investment decisionsdecisions ofof a anon—equity non—equity issuingissuing firm (again(again thethe 0 0argument argument hashas beenbeen suppressed),suppressed),

TE — TE mVE + (1—m)((1—mn)( E° )(0)(O ++ Q(KE) —(KE_e)(l+R)))(1+R)) —pE 0 V+eE° 0 yE,VE, KEKE andand P areare defineddefined analogously analogously to tovD, D,KD KDand and P. P. AssumingAssuming that c c lies inin the lover tail of aa singlesingle peakedpeaked distribution, it isis relativelyrelatively straightforwardstraightforward to show thatthat dH(0)/dOdH(0)/dO >> 0.0. Thus,Thus, thethe optimaloptimal decision rule for individualindividual firmsfirms on equity sales policy is the following,

(e if 0<0 * ) 00 — e =1 (4) tO(,0 ifIf 0>00>0 ______

—8—

where 00 isis defineddefined by H(0)H(O) =0. Given equation (4) firms entering the equity market willwill bebe adverselyadversely selected. selected. And,And, althoughalthough inin thisthis simplesimple modelmodel anan equilib-equilib- rium alwaysalways exists,exists, itit maymay be be one one with with zero zero equity equity sales. sales. However,However, ifIf 00 >>0for all firmsfirms andand in m is closeclose toto zero,zero, then an equilibrium with positive equityequity salessales will exist.exist. InIn suchsuch anan equilibrium,equilibrium, V isis determineddetermined byby the equation,

(O+Q(K) yE == i_ JO -(KE_e))N(O)dO --e, — f(° (KE_e0))N(0)dO

- - — - WUeL Ce = = JN(O)dO NE N(0)dO It is relatively easy to show that the resulting equilibriwnequilibrium level of

has the following properties under suitable regularity conditions on F,

dyE dyE dyE (i)Ci) >o,0, (ii) <0, (iii) (1+R)(1-'-R) 2.>

In each instanceinstance anan increaseincrease in in E isis associatedassociated withwith anan increaseincrease inin thethe

number of firms issuingissuing equityequity (a(a decreasedecrease in in yE isis associatedassociated withwith aa

decrease in the number of firms issuing equity).

Also, if N(O)N(0) isis normalnormal withwith variancevariance ci,c, then,

dVE/dcTdVE/dcl -<0

The optimal investment condition which characterizescharacterizes non—equitynon—equity

issuing firms is,6

fD fD KQk 0 = (1-i-R)[1+(T)( )(1)(1—_____ [1+(T)( °D)(l/Q)(1_(Q — where,fDfis the level ofof thethe e densitydensity functionfunction atat EP,C,where is thethe levellevel ofof the ce for a non—equity issuing firm atat which,which, whenwhen KK isis optimallyoptimally chosenchosen thethe firmfirm defaults (eD(c' depends,depends, ofof course,course, on on E. .The secondsecond bracketed term onon thethe right—right— hand side of (5) represents the component ofof thethe costcost ofof capitalcapital attributableattributable toto —9—

the marginalmarginal increaseincrease in in the the risk risk of of bankruptcy. bankruptcy. AsAs 00 fallsfalls (because(because aa negativenegative demand shock reduces the value of existing cash flows), this term may rise dramat—

D D 77 ically as f, andB increase.increase. Any such increaseincrease isis limited ultimately by thethe possibility ofof issuingissuing equity. However,However, equity equity issue issue becomes becomes a aviable viable alternative alternative onlyonly whenwhen thethe follow-follow- ing condition holds,

DE E0 vDe B B) v(e)_VD(0)V ( )— () c(c(BB) ++(1—m)(1+R) e e 0 0

vD_vE E °o 0) )(V (0)(0) = m( + (1—m)(1+R)( —1) (6) m(e0) + (1—m)(li-R)(E° )(V (6) V+eV-i-e V 0 0 0

VD(e) —KD) wherev'(e) = ((0+Q(K))/(1+R)—KD)which is the market valuevalue ofof aa firmfirm ofof quality 0, whose level of investment is optimal for debt finance (given 6), assuming thatthat 00 werewere observable.observable. VE(O)vE(o) isis defined analogously with replacing

KD. TheThe left—handleft—hand sideside ofof equationequation (6)(6) representsrepresents thethe differential benefitsbenefits ofof equity financefinance perper dollardollar of of equity. equity. ThisThis consistsconsists ofof thethe reducedreduced levellevel ofof bankruptcy risk and the benefits of an increased level of investment (i.e., vE(o) —vD(e)).VD(O)). The right—hand side ofof equationequation (6)(6) capturescaptures thethe differentialdifferential cost of issuing equity. It consists of a signalling cost (the firstfirst termterm onon thethe right—hand side of (6)), embodying thethe differencedifference inin thethe valuevalue ofof aa firmfirm whichwhich results from issuing equity (divided byby thethe amountamount ofof equityequity issued),issued), plusplus aa dilution cost (the secondsecond termterm onon thethe right—handright—hand sideside ofof (6))(6)) whichwhich arisesarises becausebecause a firm with aa truetrue valuevalue VE(O)VE(O) mustmust sellsell equityequity asas ifif itit hadhad aa valuevalue yE.

In practice, the "effective" cost ofof issuingissuing equityequity maymay bebe soso highhigh asas toto be prohibitive. EventEvent studiesstudies (most(most recently Asquith andand MullinsMullins (1983))(1983)) indicateindicate that an equity issue announcement reduces the value of a firm by about 3 percent.

And this maymay bebe aa substantialsubstantial underestimate underestimate since since it Itis is based based on on firmsfirms whowho actually issue equity and who are, asas aa result,result, likelylikely toto havehave thethe lowestlowest costcost ofof — 10—

a new equity issue amounts to 5 percent of a firm's doingso. Thus,Thus, ifif m 4 4andand a new equity issue amounts to 5 percent of a firm's outstanding stock, thethe signallingsignalling costcost ofof equityequity will,will, byby itself,itself, amountamount toto moremore than 30 percent.percent. ItIt isis notnot surprising,surprising, therefore,therefore, that firms rarelyrarely issueissue equity.equity.

Moreover, if strong firmsfirms enjoyenjoy anan enhancedenhanced advantageadvantage overover weakweak onesones inin thethe faceface of adverse economic conditions, a negativenegative economic surprise will increase the dispersion of N(O) and increase the costcost ofof issuingissuing equityequity justjust whenwhen itit isis mostmost

8 needed.

IV. Concluding Remarks Informational imperfections havehave aa fundamentalfundamental effecteffect onon thethe functioningfunctioning of the capitalcapital market.market. InIn somesome circumstances,circumstances, competitive marketsmarkets willwill bebe charac-charac- terized byby creditcredit rationing:rationing: itit isis the availability of capital and not itsits costcost that determines thethe levellevel of of investment. investment. Here,Here, wewe havehave providedprovided anan explanationexplanation for why firms whose credit is constrained dodo notnot availavail themselvesthemselves ofof thethe equityequity market. AndAnd wewe havehave shownshown thatthat thethe effectiveeffective marginalmarginal costcost of capital for thosethose who are not constrained is not simply related either to the real long—term interest rate (as Keynes'Keynes' hypothesized)hypothesized) oror toto thethe priceprice ofof equityequity (as(as moremore recentrecent portfolio theories have argued); the effective marginal cost of capital may experience much larger cyclical fluctuations than either of these variables.

These variations inin thethe effectiveeffective costcost ofof capital.capital inin turn play an important rolerole in explaining observed patterns of cyclicalcyclical behaviorbehavior regardingregarding bothboth investmentinvestment andand prices.

Although the formerformer effecteffect isis obvious,obvious, thethe latter latter may may not not be. be. When current prices affect not only present butbut futurefuture demanddemand (see(see PhelpsPhelps andand WinterWinter

(1970)), firms will maximize profits with a price at which short—run marginal costs lielie aboveabove short—runshort—run marginal marginal r'evenues. r'evenues. TheThe gapgap isis filledfilled byby thethe contribu—contribu-

tion ofof lowerlower pricesprices toto futurefuture profits. profits. UnderUnder thesethese circumstances,circumstances, anan increaseincrease inin

the cost of capital reduces the present value of any future market position and — 11— willlead to anan increaseincrease inin currentcurrent prices. prices. OurOur costcost ofof capitalcapital viewview leadsleads toto just such a conclusion; as a recession begins,begins, thisthis tendencytendency towardtoward higherhigher pricesprices might well counteract thethe effecteffect ofof fallingfalling demanddemand andand accountaccount forfor somesome priceprice

stickiness. InIn thisthis andand otherother waysways informationalinformational imperfections maymay provideprovide aa

consistent economic explanationexplanation forfor manymany hithertohitherto unexplainedunexplained aspectsaspects ofof macro—macro—

economic behavior. — 12—

FOOTNOTES

1. There areare well—knowiiwell—known impediments,impediments, both theoretical andand practical,practical, toto share- share-

holder control whether mediatedmediated viavia takeoverstakeovers oror normalnormal corporatecorporate governance.governance.

2. ForFor simplicity,simplicity, existing netnet cashcash flowsflows areare assumed assumed to to be be certain. certain. MakingMaking

existing cash flows uncertain would merelymerely complicatecomplicate thethe analysisanalysis andand

reinforce the basic results.

3. TheThe model,model, asas presented,presented, involvesinvolves onlyonly a single period butbut cancan bebe easilyeasily

extended to a sequence of periods with independent 0 draws in each period.

4. TheThe restrictionrestriction toto discretediscrete levelslevels ofof equityequity sales, though made primarilyprimarily forfor

expositioiaalexpositional convenience,convenience, hashas certaincertain importantimportant theoreticaltheoretical justificationsjustifications

and consequences.

5. In order that each classclass includeinclude firmsfirms withwith moremore thanthan aa singlesingle valuevalue o0o0

neither KK nornor bb maymay bebe perfectlyperfectly observableobservable to to equity equity investors. investors. However,However,

given current accounting conventions andand thethe timingtiming ofof debtdebt reportsreports thisthis isis

not implausible.

6. AA similarsimilar conditioncondition wouldwould applyapply forfor equityequity issuing fir*sfirzs becausebecause theythey areare

limited toto issuingissuing onlyonly e0e0 dollars dollars of of equity. equity. ThisThis isis anan artifactartifact ofof ourour

assumptions.

KQk 0 7. J 0 0declines, declines, the the termterm (1—((1—( )(1_K(1+R))) decreases, partiallypartially offsettingoffsetting

the impact on the marginal cost of capital of the factors cited above.

However, this effecteffectis is inin largelarge measuremeasure anan artifactartifact ofof thethe simplesimple wayway InIn

which uncertainty isis embodiedembodied inin thethe model.model. IfIf Cc affectsaffects bothboth 66 and Q(k),

then the corresponding term in the resultingresulting expressionexpression forfor thethe marginalmarginal costcost

of capital tends to increase as 0 declines.declines.

8. TheThe dilutiondilution costcost alsoalso risesrises underunder thesethese circumstancescircumstances as falls relative

to V0(0).V0(O). And,And, asasV falls,falls, thethe costcost ofof raisingraising e0e0 dollarsdollars ofof equityequity

embodiedetnbodiedin in the factor (V)/(V+e0) rises. ______

— 13—

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