2. Moral Hazard- Fixed Investment Flashcards
What does A stand for?
Cash/ net worth of the entrepreneur/borrower that can be either invested or used for consumption
What happens if the project succeeds and entrepreneur exerts effort?
The project will yield no private benefit
What happens if the project succeeds but the entrepreneur exerts no effort?
The project will yield private benefit B>0
What is delta P?
Delta P= Ph-Pl
What are the preferences of the entrepreneur and potential lenders?
Risk neutral. There is no time preference
How does the loan market work?
The riskless rate is equal to 0, the market is competitive (loan makes zero profits) and the borrower is protected by limited liability
What do the entrepreneur and lenders earn if the project is successful?
Entrepreneur receives Rb and lenders earn Rl
What is the rate of interest rate given by?
Rl= (1+i)(I-A) or 1+i = 1/Ph
What is the zero profit constraint for the lenders
PhRl= I-A
Under the assumption that the loan agreement induces the borrower to exert effort
When does the project have a positive NPV?
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
When will the entrepreneur exert effort?
If the following incentive comparability constraint is satisfied
PhRb>= PlRb + B
Delta P x Rb>= B
What does the incentive compatibility constraint imply the highest income in the case of success that can be pledged to lenders is?
R-B/delta P
When will lenders offer a loan?
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
Why do we assume that Ā>0?
Because otherwise even an entrepreneur with zero net worth would be able to obtain a loan
Proposition 1. When is there credit rationing and what happens in this case?
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
Proposition 2. What is the necessary and sufficient condition for project financing?
A>=Ā is both a necessary and sufficient condition for project financing
What is the agency rent?
It is the min expected payoff for the entrepreneur that preserves incentives PhB/delta P
What is the entrepreneur’s utility given by if A>=Ā?
PhRb-A= Ph(R-Rl)-A= PhR-I
The entrepreneur received the entire social surplus
Proposition 3 what does the extent of credit rationing depend on?
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)
Empirically does the investment- cash flow sensitivity increase with the extent to which the firm is financially constrained?
-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
What do G(A) and g(A) denote?
The distribution and density functions of A
When is the sensitivity of investment to cash flow higher for a firm with a low agency cost?
If the density is decreasing
What does D denote?
Debt owed from past borrowing to a group of initial investors
Proposition 4. When will a profitable project not be financed because of debt?
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
What can initial investors do when there is debt overhang and what do they gain from this?
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
What is the max amount that can be pledged to new investors?
R-B/delta P -D in the case of success
When would new investors be willing to finance a project?
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
Proposition 5 under what conditions will a new investor fund the project?
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.
What is limited liability?
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.
What is the timeline of this model?
Loan agreement > investment > moral hazard > outcome
What is Ā equal to?
Ā= Ph(B/delta P - R) + I
How does the pledgable income relate to the agency cost?
An increase in the pledgable income means a decrease in agency cost
What does the size of debt forgiveness depend on?
The bargaining power of the parties.
Suppose that Ā<0. What are the implications of this for credit rationing.
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.
Suppose Ph and Pl decrease by the same amount. How would that change affect the results of the model?
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
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.
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.
When there is debt forgiveness and a new investor finances the project what do the the new investors, initial investors and borrower each get?
New investor Ph(R-B/(delta P) -d)=I
Initial investor gets Phd=-Ā>0
Borrower gets PhB/delta P
