Concept Questions Flashcards
- What is a principal-agent relationship? What is a principal-agent problem? Give an example
A principal-agent relationship is when one party (the principal) contracts with another (the agent) to take some action on their behalf. A principal-agent problem is when the agent is motivated to act in their own best interest (via a hidden action) to the detriment of the principal. An example is an employer (principal) and an employee (agent), where the employer can’t monitor all actions taken by the employee, so there is a risk that the employee pursues personal benefits instead of doing what the employer would want.
- In the context of a principal-agent relationship, what does it mean for the agent’s contract with the principal to be incentive compatible? What is the key idea behind incentive compatibility? Give an example
A contract is incentive compatible if it motivates the agent to take actions according to the principal’s best interest. Key idea: Make the agent’s payoffs contingent on events that are related to the agent’s hidden action/principal’s payoffs.
- Incentive compatibility involves aligning the interest of the agent with that of the principal (skin in the game), so they won’t pursue personal interests at the expense of the principal.
An example is to offer a manager/employee bonuses based on performance instead of awarding them with a fixed salary.
- Describe a situation in which moral hazard leads to financial constraints. What are some steps (at least 2) that firms can take to mitigate financial constraints induced by moral hazard?
A moral hazard is a situation when one party is inclined to take risks since they do not bear the full consequences of that risk. For example, managers may be temped to choose “bad” projects if they offer a private benefit. This can limit how much financing a firm can raise (so that not all NPV positive investments can be made).
- Can be partially overcome by paying managers based on performance (incentive compatible contracts).
- Good corporate governance can also relax the financial constraint: credible commitment to reduce private benefits and increase monitoring.
- What is information asymmetry? Describe the lemon problem.
Information asymmetry is a situation in which one party to a transaction has more payoff relevant information than the other. The less informed part faces an adverse selection problem, in which the more informed party rigs the trade against the less informed.
The lemon problem is when firms (sellers) know more about their riskiness (type) than the bank does. Firms may claim to be less risky (higher quality) than they actually are. The bank (buyer) worries that the debt contract will be disadvantageous because of the information asymmetry.
- Why do less sophisticated (uninformed) investors face a winner’s curse problem when subscribing to IPOs? What the is end-result for firms seeking equity financing?
Uninformed investors face a winner’s curse problem when subscribing to IPOs because they receive a larger allocation of “bad” IPOs and a smaller allocation of “good” IPOs (when informed investors opt out of bad investments). The concern over the winner’s curse makes less informed buyers less willing to offer a high price. Severe winner’s curse problems can lead a firm to pass of NPV positive projects. This results in IPO underpricing where good firms get worse terms of equity financing.
- In the context of a market with sellers of different qualities, describe a pooling equilibrium.
The “good-type” firm gets worse terms than it does in the perfect information benchmark, and the “bad-type” firm gets better terms than it does in the perfect information benchmark. In essence, the good types subsidize bad types because of information asymmetry.
- In the context of a market with an adverse selection problem, what are the key ingredients of a market failure, in which certain types of sellers are missing from the market when they are present in the perfect information benchmark?
A market failure (induced by adverse selection) describes a scenario in which certain types of sellers are missing from the market when they are present in the perfect information benchmark. Key ingredients:
- Sellers have private information about their types.
- The price dictated by the average quality of all sellers is too low for high quality sellers.
- In the context of a market with sellers of different qualities, describe a separating equilibrium.
A separating equilibrium prevails when both types of sellers are in the market and the buyer can distinguish between them because the sellers offer different terms. In general:
- Low quality sellers receive the same terms that they would have received in the perfect information benchmark.
- High quality sellers bear the cost of signaling.
- High quality sellers receive worse terms than they would have received in the perfect information benchmark (if signaling is costly).
- In the context of a market with information asymmetry, what does signaling mean? What are the key ideas behind signaling?
Signaling implies actions by the more informed to credibly reveal their private information to the less informed. Key idea:
- Find an action that is more costly for the imitator than the imitated.
- If the cost of taking the action exceeds the benefit from imitation, the imitator will stop imitating.
- The informed chooses to signal if it leads to a better private outcome than in the pooling equilibrium.
- In the context of a market with information asymmetry, what does screening mean? What are the key ideas behind screening?
Screening implies actions by the less informed that allows it to infer the private information of the more informed. Key idea:
- The less informed offer a menu of choices.
- Each choice corresponds to the more informed party’s private information.
- Deduce the informed party’s private information by observing their choice.
- What is a real option? Why do real options have value? (hint: there are two main ingredients)
A real option is the right to make an adjustment/decision to the project after new information is learned, which adds value to an investment opportunity. Two conditions must be satisfied:
- Uncertainty about key factors in a business decision.
- The optimal strategy depends of those factors.
- Sometimes projects have different stages and the firm can exercise discretion in their timing. What are some trade-offs that the firm faces in selecting the optimal project staging?
When we can choose how to stage a project, all else equal:
- Stages that provide more information should be done earlier (increases the value of real options by eliminating more uncertainty).
- Stages that require more initial capital should be done later (results in capital cost savings by deferring costs into the future).
- Stage together only if there are significant cost savings, e.g. economies of scale/scope or high time discounting of payoffs (saves time).
- What are some common types of real options?
- Option to expand (growth option, invest in the future).
- Option to abandon (option to reduce the scale of investment in the future).
- Option to stage/delay. Always better to wait unless there is a cost to doing so.
- What are some limitations of using real options as part of a valuation technique?
- Unlike with financial options, there are no historical prices with which to estimate volatility.
- Requires projections about how future decision makers will proceed.
- The value of a real option is often sensitive to the estimates about the likelihood of scenarios (e.g. probability that the first move is successful).
- What are some costs associated with real options? (name at least 3)
- Direct costs. The real option is something that the firm has to pay for since it adds value.
- Lost profits in the interim. The real option to delay has a cost because it pushes back payoff, which results in a lower NPV due to time value.
- Competitors get a head start. Often, firms are racing to bring product to market. To the extent that there is a first-mover advantage, waiting to act until more information is known may be costly.
- Costs may rise. Could save some production costs due to economies of scale. Waiting results in an additional production cost.
- May exacerbate agency problems.
