Asymmetric information, asset substitution, and the design of securities

The purpose of the this paper is to study the design of securities when a firm must raise external capital from an asymmetrically informed capital market and when the firm has operating discretion in the management of the capital raised that embodies the essence of the asset substitution problem. It is shown that in this setting, if the operating discretion is sufficiently broad, there is no dissipation of value from asset substitution and hence no agency costs of this incentive problem, but the security design problem is severely constrained. Optimal operating policy decisions result in limiting security designs essentially to convex claims on firm cash flow. In this context, both equity and levered equity (the residual claim being inside debt) are natural candidates for optimal security designs. We characterize the private productivity information of the firm that yields equity as an optimal security design. This characterization involves an intuitive comparison of indices of mispricing gains of equity vis-a-vis those of levered equity. The relevant conditions are satisfied in a varietyof contexts, but they are not universal. We then pursue further the security designs that minimize mispricing and we show that in this context the optimal security designs are scaled versions of levered equity, which includes the conditions under which equity is optimal as a limiting case. This gives theoretical foundation for the use of inside debt in managing the asset substitution problem even when there are no agency costs of asset substitution.