8. Moral Hazard Term Structure & Adverse Selection

Question 1

What does liquidity management consider?

Answer 1

We consider the optimal financing problem when entrepreneurs face uncertain liquidity needs. In particular, we consider an environment where at the time that a contract is agreed there is uncertainty about the future liquidity needs of the firms

Question 2

Main conclusions of liquidity management

Answer 2

Cash- rich firms issue short term debt, long term debt and also use retentions (retained profits)
Cash-poor firms finance their projects with credit lines (loan commitments)

Question 3

Timing of the model

Answer 3

Date 0: contract and investment
Date 1: short term income- random investment need
Date 2: moral hazard
Date 3: outcome
This is a simple extension of the fixed investment model where an intermediate step has been added

Question 4

What is F(rho) and f(rho)

Answer 4

Cumulative distribution function and density of reinvestment

Question 5

What happens if the entrepreneur doesn’t reinvest?

Answer 5

The firm is liquidated

Question 6

What is the liquidation value of the firm?

Answer 6

0

Question 7

How much lower is pledgable income than the corresponding revenue in the case of success?

Answer 7

B/delta P less which is the min amount that the entrepreneur must receive so that he has incentives to exert effort

Question 8

When should the investment be salvaged?

Answer 8

When the cost, rho, of a rescue is less than the expected payoff PhR of continuing

Question 9

What is the most investors can claim?

Answer 9

Ph(R-B/delta P) given that they need to give incentives to the entrepreneur to exert effort in the case of continuation

Question 10

When is utility and pledgable income increasing/decreasing?

Answer 10

It is increasing for low values of rho* and decreasing for high values of rho*

Question 11

When does utility reach its highest value relative to pledgable income and why?

Answer 11

Utility reaches its highest value at a higher value of the continuation threshold since the marginal benefit of continuation is lower for pledgable income than for utility while the marginal costs are the same

Question 12

What happens in case 1 and case 3?

Answer 12

In case 1 the contract is indeterminant and in case 3 there is no contract

Question 13

Proposition 1 how can the optimal contract be implemented when r>=rho*

Answer 13

The optimal contract can be implemented through a combination of short term debt d= r-rho* and long term debt D=R-B/delta p

Question 14

Proposition 2 how can the optimal contract be implemented when r=0?

Answer 14

The optimal contract can be implemented by an initial loan I-A and a nonrevokable credit line at level rho*

Question 15

Why must the credit line be nonrevokable?

Answer 15

If rho> ph(R-B/delta p) the investor has an incentive not to rescue the firm. The reason is that in expectation the investor breaks even which implies that if liquidity needs are high but lower than rho* the investor expects to make losses

Question 16

Types of adverse selection

Answer 16

Asymmetric info between insiders and investors. Investors might have imperfect info of
- firms prospects
- the value of assets in place
- the value of pledged collateral
- the issuers potential private benefit

Question 17

Consequences of adverse selection

Answer 17

-Market breakdown
-cross subsidisation
-over investment
-underinvestment

Question 18

Summarise the privately known prospects model assumptions

Answer 18

-entrepreneur: risk neutral, limited liability, A=0
-credit market: competitive, lenders are risk neutral, risk free interest rate equals 0
-project: requires investment I, yields R in the case of success and 0 in the case of failure

Question 19

Probability of good entrepreneur succeeding

Answer 19

P

Question 20

Probability of bad entrepreneur succeeding

Answer 20

q

Question 21

What are the two subcases of the privately known prospects model?

Answer 21

-PR>I>qR (only good type is credit worthy)
-PR>qR>I (both types are credit worthy)

Question 22

What is the probability that the entrepreneur is a p-type or q-type

Answer 22

Alpha for p-type
1-alpha for q-type

Question 23

What is m equal to?

Answer 23

m= alpha x p + (1- alpha)q

This is the lenders prior probability of success

Question 24

What is Rb^G given by in symmetric info model?

Answer 24

The lenders break even condition
P(R-Rb^G)=I

Question 25

When does the bad entrepreneur obtain finance in the symmetric info model?

Answer 25

If qR>I the bad entrepreneur obtains finance and Rb^B is given by
q(R-Rb^B)= I

Question 26

Why isn’t the symmetric info outcome robust to asymmetric info?

Answer 26

Because the bad entrepreneur can pretend to be a good entrepreneur and derive greater utility

Question 27

Proposition 1 adverse selection

Answer 27

If mR<I the market breaks down. Good entrepreneur don’t obtain finance (underinvestment)

Question 28

Proposition 2 adverse selection

Answer 28

Lenders make money on the good type (p(R-Rb)>I) and lose money on the bad type (q(R-Rb)<I) there is cross subsidisation when the bad entrepreneur isn’t credit worthy there is overinvestment

Question 29

Pecking order hypothesis

Answer 29

There is no distinction between debt and equity when the return of the investment is either R or 0. Project yields R^F in the case of failure and R^s in the case of success where R^s-R^F=R

Question 30

What is the break even condition?

Answer 30

m(R^s-Rb^s)+(1-m)(R^F-Rb^F)>=I

Question 31

What does the good entrepreneur maximise?

Answer 31

PRb^s+(1-p)Rb^F

Question 32

What does the adverse selection discount increase and decrease with?

Answer 32

Increases with Rb^F and decreases with Rb^s

Question 33

Proposition 3 adverse selection

Answer 33

Optimal capital structure: the entrepreneur issues safe debt equal to the salvage value R^F and issues risky equity with payoffs R^s-Rb^s in the case of success and 0 in the case of failure

Question 34

Why does safe debt minimise cross subsidisation?

Answer 34

Because it is a low info intensity claim and it isn’t sensitive to the entrepreneurs private info

Question 35

How can good types separate from bad types?

Answer 35

By introducing distortions that are costly to them but would be even costlier to bad types.
-certification
-collateral pledging
-short term maturities
-payout policy (dividends)

Question 36

What is rho?

Answer 36

Reinvestment unknown at date 0, known at date 1

Question 37

What is r?

Answer 37

Deterministic and verifiable income

Question 38

What is the cutoff value?

Answer 38

Cutoff value of rho, rho, such that it is optimal to continue if rho<=rho. The probability of continuation is Pr(rho<=rho)=F(rho)

Question 39

Why does the contract for cash poor firms stipulate that the loan commitment is non-revocable?

Answer 39

In expectation the lender makes zero profits. In some cases the bank will make negative profits but it must commit to this and can’t revoke it

Question 40

Suppose B=0. How would this change affect the results?

Answer 40

When B=0, pledgable income and utility become exactly the same so you try to maximise utility

Question 41

When does underinvestment occur?

Answer 41

mR<I
This case can only arise when the bad entrepreneur is not creditworthy and alpha<alpha*

Question 42

When does overinvestment occur?

Answer 42

When the bad isn’t creditworthy and alpha>=alpha*

Question 43

What is the lenders profit in the asymmetric case?

Answer 43

(Alpha p + (1- alpha)q)(R-Rb)-I=m(R-Rb)-I

Question 44

How is the value of alpha* determined?

Answer 44

Let alpha* such that
alpha(pR-I)+(1-alpha)(qR-I)=0