Can you please explain how Risk management increase firm value Information asymmetry

[prakashsista]

Hi,
in the case of information asymmetry, If the managers know more information than the outsiders , why is it costly for management to raise funds? How is it going to reduce the cost by involving an outside large shareholder in the board ? Can you pls eloborate a bit.

 

[David Harper CFA FRM]

@prakashsista This is classic Stulz. If you are an investor who suffers from information asymmetry, then you know (much) less than management about the company, or a company's project. One way to cope with the uncertainty (lack of information) is to charge a higher price for your investment funds (making it more costly for management)! Maybe 1.0% of the company is worth $2.0 million but due to the investor's uncertainty (caused by info asymmetry), the investor will pay only $1.0 million: the funds are twice as expensive due to the discount.

I would compare this (analogy only) to being a small angel/VC investor in a private company: expensive equity is often sold to angels who effectively lack information. But private equity, on the other hand, can come in and take a concentrated position in a company, get to know it really well, and as their information asymmetry problem is reduced, they are willing to invest at more reasonable prices (less of a discount, so less expensive to company). In theory, if a large private equity firm knows the company (almost) as well as management, they could purchase equity at nearer to fair value. (this is even before the feedback loop caused by monitoring). Thanks,