2. Moral Hazard- Fixed Investment

Question 1

What does A stand for?

Answer 1

Cash/ net worth of the entrepreneur/borrower that can be either invested or used for consumption

Question 2

What happens if the project succeeds and entrepreneur exerts effort?

Answer 2

The project will yield no private benefit

Question 3

What happens if the project succeeds but the entrepreneur exerts no effort?

Answer 3

The project will yield private benefit B>0

Question 4

What is delta P?

Answer 4

Delta P= Ph-Pl

Question 5

What are the preferences of the entrepreneur and potential lenders?

Answer 5

Risk neutral. There is no time preference

Question 6

How does the loan market work?

Answer 6

The riskless rate is equal to 0, the market is competitive (loan makes zero profits) and the borrower is protected by limited liability

Question 7

What do the entrepreneur and lenders earn if the project is successful?

Answer 7

Entrepreneur receives Rb and lenders earn Rl

Question 8

What is the rate of interest rate given by?

Answer 8

Rl= (1+i)(I-A) or 1+i = 1/Ph

Question 9

What is the zero profit constraint for the lenders

Answer 9

PhRl= I-A
Under the assumption that the loan agreement induces the borrower to exert effort

Question 10

When does the project have a positive NPV?

Answer 10

If the entrepreneur exerts effort the project has positive NPV PhR-I>0
If the entrepreneur doesn’t exert effort then the project has negative NPV PlR-I+B<0

Question 11

When will the entrepreneur exert effort?

Answer 11

If the following incentive comparability constraint is satisfied
PhRb>= PlRb + B
Delta P x Rb>= B

Question 12

What does the incentive compatibility constraint imply the highest income in the case of success that can be pledged to lenders is?

Answer 12

R-B/delta P

Question 13

When will lenders offer a loan?

Answer 13

When the following participation constraint is satisfied
Ph(R-B/delta P) >=I-A
Thus a necessary condition for a loan is A>=Ā
Where we assume Ā>0

Question 14

Why do we assume that Ā>0?

Answer 14

Because otherwise even an entrepreneur with zero net worth would be able to obtain a loan

Question 15

Proposition 1. When is there credit rationing and what happens in this case?

Answer 15

When A<Ā there is credit rationing. Projects with the positive NPV will not be financed despite the willingness of entrepreneurs to pay high interest rates

Question 16

Proposition 2. What is the necessary and sufficient condition for project financing?

Answer 16

A>=Ā is both a necessary and sufficient condition for project financing

Question 17

What is the agency rent?

Answer 17

It is the min expected payoff for the entrepreneur that preserves incentives PhB/delta P

Question 18

What is the entrepreneur’s utility given by if A>=Ā?

Answer 18

PhRb-A= Ph(R-Rl)-A= PhR-I
The entrepreneur received the entire social surplus

Question 19

Proposition 3 what does the extent of credit rationing depend on?

Answer 19

The extent of credit rationing (financial constraints) depends on:
1. The level of net worth A (negatively)
2. The level of interest rate r (positively; supposing that r>0 then the participation constraint becomes Ph(R-B/delta P) >= (1+r)(I-A)
3. The level of agency costs (a) private benefit B (positively), and (b) likelihood ratio delta P/Ph (negatively the higher the ratio the better the performance measurement)

Question 20

Empirically does the investment- cash flow sensitivity increase with the extent to which the firm is financially constrained?

Answer 20

-Fazzari et al 1998 using a priori measures of financial constraints find that the sensitivity is larger for firms having trouble raising external funds.
-Kaplan & Zingales 1997 argue that there is no theoretical basis for this relationship and present empirical evidence that differs from the one above

Question 21

What do G(A) and g(A) denote?

Answer 21

The distribution and density functions of A

Question 22

When is the sensitivity of investment to cash flow higher for a firm with a low agency cost?

Answer 22

If the density is decreasing

Question 23

What does D denote?

Answer 23

Debt owed from past borrowing to a group of initial investors

Question 24

Proposition 4. When will a profitable project not be financed because of debt?

Answer 24

If A>Ā>A-D>=0 then the new project that would have been financed in the absence of past borrowing will not be undertaken. Recall that the pledgable income net of investments is equal to Ph(R-B/delta P)-I new investors obtain at most Ph(R-B/delta P) -I-D+A= A-D-Ā<0 which implies they can’t break even

Question 25

What can initial investors do when there is debt overhang and what do they gain from this?

Answer 25

They can forgive existing debt, finance the new investment I, and demand the entire cash-flow rights attached to the external shares, that is R-B/delta P. The initial investors then obtain Ph(R-B/delta P)-I = -Ā>0 and the borrower gets PhB/delta P>0

Question 26

What is the max amount that can be pledged to new investors?

Answer 26

R-B/delta P -D in the case of success

Question 27

When would new investors be willing to finance a project?

Answer 27

If Ph(R-B/delta P - D) >=I or Ā+ PhD<=0 which contradicts our initial assumption so this won’t ever happen unless there is debt forgiveness

Question 28

Proposition 5 under what conditions will a new investor fund the project?

Answer 28

Unless the borrower renegotiated some debt forgiveness from initial investors the project will not be funded. This inability to renegotiate leads to debt overhang.
Debt forgiveness would need to happen where Ā + Phd=0 then since Ph(R-B/(delta P) -d)=I the breakeven constraint is satisfied.

Question 29

What is limited liability?

Answer 29

A legal structure that limits the extent of economic loss to assets invested in an organisation. It prevents individuals from being held personally responsible for their company’s financial losses.

Question 30

What is the timeline of this model?

Answer 30

Loan agreement > investment > moral hazard > outcome

Question 31

What is Ā equal to?

Answer 31

Ā= Ph(B/delta P - R) + I

Question 32

How does the pledgable income relate to the agency cost?

Answer 32

An increase in the pledgable income means a decrease in agency cost

Question 33

What does the size of debt forgiveness depend on?

Answer 33

The bargaining power of the parties.

Question 34

Suppose that Ā<0. What are the implications of this for credit rationing.

Answer 34

There will be no credit rationing. The project is so profitable that the lender doesn’t need to provide incentives for the borrower to exert effort.

Question 35

Suppose Ph and Pl decrease by the same amount. How would that change affect the results of the model?

Answer 35

Incentives are the same but the project is less profitable. Pledgable income is lower Ph(R-B/delta P) so it is less likely to be >= I-A therefore the project is less likely to be funded

Question 36

Evaluate the statement: the likelihood that a project is financed when the borrower has other debt obligations is independent of whether existing investors or new investors provide the funds.

Answer 36

It doesn’t depend on whether existing investors or new investors provide the funds. It is dependent on bargaining power. Either way the old contract must be thrown away and a new one made.

Question 37

When there is debt forgiveness and a new investor finances the project what do the the new investors, initial investors and borrower each get?

Answer 37

New investor Ph(R-B/(delta P) -d)=I

Initial investor gets Phd=-Ā>0

Borrower gets PhB/delta P