Concept questions

Question 1

What is a principal-agent relationship? What is a principal-agent problem? Give an example

Answer 1

It occurs when the principal contracts with an agent to take some action on their behalf. The problem is when the agent is motivated to act in their own best interest (via a hidden action) at the cost of the principal. Common examples are employer and employee, shareholders and management, bank and borrower, citizen and politician, insurer and policy holder

Question 2

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

Answer 2

A contract is incentive compatible if it motivates the agent to take actions according to the principal’s best interest. Key idea is to make the agent’s payoff contingent on events that are related to the agent’s hidden action/principal’s payoffs i.e. set provision-based wages for employees

Question 3

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?

Answer 3

If an entrepreneur has a business and has the opportunity to pursue private benefits (self-dealing, lavish parties or pet projects) at the expense of the firm which might lower success probability. To make the contract incentive compatible, the entrepreneur will require a too large share of equity so that the project will be negative NPV for the investor and therefore will not provide the financing.

A credible commitment to reduce the private benefits can help relax the financial constraint (importance of having quality boards, experienced, diverse, independent to lower the cost of borrowing indirect and direct)
Cash or equivalent collateral can help relax the financial constraint (payout policy and capital structure are not irrelevant)
Pay their CEO based on performance

Question 4

What is information asymmetry? Describe the lemon problem.

Answer 4

Describes a situation in which one party to a transaction has more payoff relevant information than the other. The less informed one faces an adverse selection problem, in which the more informed party rigs the trade against the less informed.

Lemon problem: A car market with different types of qualities of cars but the buyers do not know the quality of the cars and will therefore only want to pay an average price to not risk to pay a too high price for a lemon.

Question 5

Why do less sophisticated (uninformed) investors face a winner’s curse problem when subscribing to IPOs? What is end-result for firms seeking equity financing?

Answer 5

The uninformed investors understands when the project is likely to succeed, they have to compete with sophisticated investors for IPO allocation. However, when the project is likely to fail, they will receive the entire IPO allocation. Hence, subscribing to the IPO without being informed means that they are more likely to get shares in a “lemon” firm. The less informed buyers worry that they will overpay in the transaction. The concern over winner’s curse makes less informed buyers less willing to offer a high price. Provides a potential explanation for the IPO underpricing phenomenon, severe winner’s curse problems can lead to a firm to pass on NPV positive projects.

Question 6

In the context of a market with sellers of different qualities, describe a pooling equilibrium.

Answer 6

Prevails when different types of sellers are in the market and the buyer cannot distinguish between them. The buyer pays a price that reflects the average quality of sellers in the marker. Higher quality sellers sell their goods (product, service, financial security) at a lower price, relative to the perfect information benchmark. Lower quality sellers sell their goods at a higher price, relative to the perfect information benchmark

Question 7

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?

Answer 7

Sellers have private information about their types and the price dictate by the average quality of all sellers is too low for high quality sellers

Question 8

In the context of a market with sellers of different qualities, describe a separating equilibrium.

Answer 8

Prevails when both types of sellers are in the market and the buyer can distinguish between them because of the sellers offering 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

Question 9

In the context of a market with information asymmetry, what does signaling mean? What are the key ideas behind signaling?

Answer 9

Signaling describes action by the more informed to credibly reveal their private information to the less informed. The key idea is to 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

Question 10

In the context of a market with information asymmetry, what does screening mean? What are the key ideas behind screening?

Answer 10

Describes actions by the less informed that allows it to infer the private information of the more informed. The key idea is that the less informed offers a menu of choices, each choice correspond to the more informed party’s private information. Deduce the informed party’s private information by observing their choice.

Question 11

Why do real options have value? (hint: there are two main ingredients)

Answer 11

Real options have value because of uncertainty about key factors in a business decision and that the optimal strategy depends on those factors. It is the right to make an adjustment to the project after new information is learned. Being able to adjust its strategy once more information is learned provides the firm with value.

Question 12

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?

Answer 12

Stages that provide more information should be done earlier (increases the value of the real option), New info from the first stage, scale economics, stages that require more initial capital s hould be done later (delay investment)  save capital costs

Question 13

What are some limitations of using real options as part of a valuation technique?

Answer 13

There are no historical prices with which to estimate volatility, unlike with financial options. The value of a real option is often sensitive to the estimates about the likelihood of scenarios. Requires projections about how future decision makers will proceed. May exacerbate agency problems (i.e. with debt?)

Question 14

What are some costs associated with real options? (name at least 3)

Answer 14

Direct costs: real options provide value for bidders, the bids increase to reflect the added value
Lost profits in the interim: real option to delay can have a cost because it may push back payoff by several periods which results in a lower NPV due to time value
Costs may rise: Could have saved costs due to economies of scale but waiting to make the second project after waiting for more information results in additional costs.
Competitors get a head start: If there is a first-mover advantage, waiting to act until more information is known may be costly

Question 15

What are some benefits of sensitivity analysis? (name at least 2)

Answer 15

Sensitivity analysis examines how much a particular NPV calculation changes when the underlying assumptions are altered.

Shows whether the investment decision is robust.
Identifies where more information is needed
Identifies the areas that deserve the most managerial attention

Question 16

What are some limitations of sensitivity analysis (name at least 2)

Answer 16

Even the best case and worst case estimates are wrong
Variables are examined in isolation when they are related since only one parameter changes at a time holding all others fixed at the expected value
Best and worst case estimates are not associated with likelihood

Question 17

What are some benefits of scenario analysis? (name at least 2)

Answer 17

Scenario analysis considers the effect of changing multiple project parameters on the NPV analysis

Shows how different parameters interact
Provides information about what outcomes are likely
Provides information about the shadow price of economic factors that the firm can control (i.e. how much is an effective marketing campaign worth?)

Question 18

What are some limitations of scenario analysis (name at least 2)

Answer 18

Selecting likely scenarios is not an exact science, much relies on business judgement
Important economic connections between sets of parameters may be overlooked, not feasible to exhaust all possible scenarios, some relationships between parameters will be overlooked
Analyzing the many combinations of different parameter value is cumbersome

Question 19

What are some advantages of Monte Carlo Simulations (name at least 2)

Answer 19

A technique that relies on repeated random samplings to model uncertainty in complex economic interactions.

Can explicitly specify the interaction between different parameters
Does not require an exact model (mathematical formula) of how outcome variables depend on the input parameters, can be done by simpler if-then statements
Simulations can deepen a forecaster’s understanding of complicated economic scenarios (For example, the previous Monte Carlo simulations teaches us that the benefits of securitizing and tranching mortgages depends on the correlation between the individual mortgages contained in the portfolio.)

Question 20

What are some limitations of Monte Carlo Simulations (name at least 2)

Answer 20

• Monte Carlo is not exactly “model-free”; it requires assumptions about how decisions in economic interactions are made - For example, we made the assumption that if the homeowners lose their job, they will be unable to pay off the mortgage.
• Computer outputs are devoid of economic intuition - For example, in the case of correlated home prices, the simulation is able to show that defaults increase. However, the mapping of the scenario to a housing bubble requires economic judgement that the analyst brings in from outside the simulations.
• The distribution of each variable and the interactions between them are difficult to model
The simulation shown on the previous slides used simple binomial distributions. There are countless other possible candidates (normal, exponential, beta, etc). Ex-ante, it is not clear which distribution best describes reality.
• At some point, even the Monte Carlo method requires input of information from experts

Question 21

Describe an information cascade (you can do this in the context of the jar game if it helps)

Answer 21

Occurs when external information overrides one’s own information, regardless of the relative correctness of the former. Key ingredients are decision with limited actions space (e.g. yes/no) e.g. only yellow and red in the jar game and outside information influences this decision. In the example of the jar game, a cascade occurs because later players were able to observe the guesses of the earlier players

Question 22

What are some advantages and limitations of using the Delphi Method to illicit opinions from experts? (name at least one of each, and at least 3 total)

Answer 22

Advantages:
• Anonymity reduces impact of dominant personalities and allows differences of opinions to be non-adversarial
• Responses are weighted equally so no one person can shift the opinions of the group
• Controlled feedback reduces noise and allows participants benefit from others’ information
Limitations:
• Requires commitment from participants who must answer a similar question multiple times
• Does not allow for discussion or extended elaboration of their views
• Consensus does not automatically mean correctness
• Completing multiple rounds may be very time consuming

Question 23

What are some indirect costs of financial distress (name at least 3)

Answer 23

• Customers may be reluctant to purchase from a company under distress if the value of the product/service depends on the company operating in the future
• Firms usually purchase goods and services from suppliers on credit. Suppliers may be reluctant to supply financially distressed firms
• Employees are often incentivized career advancements within the firm (i.e. promotions). Employees at financially distressed firms may not work as hard and may even leave
• Financially distressed firms may pass up NPV positive projects (debt-overhang)

Question 24

In the context of financial distress, what is meant by inefficient liquidation?

Answer 24

Occurs when a firm is shut down and its assets sold for less than the present value of future cash flows from the firm’s continuing operations

Question 25

What are the key ingredients underlying inefficient liquidation? (there are 2)

Answer 25

• Information asymmetry – creditors cannot tell if the future payoff of the firm is high or low
• Moral Hazard – owners of the firm who know that the future payoff of the firm is low derives private benefits from delaying the firm’s liquidation.

Question 26

Why is comparing leasing to buying with equity financing an unfair comparison?

Answer 26

Payments to equity holders are not tax deductible, whereas payments to lessors are. Therefore it is unfair to compare leasing to buying with equity financing unless you account for the tax advantage of leasing. This means that when discounting the differences in cash flows due to leasing, we should use an after-tax interest rate

Question 27

Give an example of an increased cost (name this cost) when an asset is leased rather than purchased outright?

Answer 27

A lessee might overuse/misuse an asset due to the lack of ownership and interest in its residual value. The lessor anticipates this moral-hazard cost and increases the effective cost of using the asset as compensation.

Question 28

When an asset is only needed for a short period of time, give an example of an increased cost (name this cost) when an asset is purchased outright rather than leased?

Answer 28

Transfer of ownership often involves significant direct costs (legal, intermediation) and significant indirect costs (inspection, discounting due to adverse selection). Leasing involves acquiring the right to use an asset without a transfer of ownership and is therefore often cheaper than buying.

Question 29

In the course we saw how contracting can mitigate some problems associated with moral hazard (incentive compatibility) and adverse selection (screening, signaling). In particular, if we can contract on everything, then there would be no problems associated with moral hazard and adverse selection. What are some limits of contracting?

Answer 29

• Some actions cannot be observed (hidden actions)
o How hard an entrepreneur works
o The intent of a business strategy
• Some qualities cannot be observed (hidden information)
o The viability of a technology
o The riskiness of a driver (for insurance)
• Some actions/qualities can be observed but not easily proven in court (verifiability)
• Contracts can only be written on observable and verifiable outcomes (investment, profits, asset value)

Question 30

What are some common restrictions on financial securities? (Name 2) Give one rationale for why one of those restrictions exist.

Answer 30

• Limited liability (legal)
o The entrepreneur cannot be forced to pay investors more than the company’s assets are worth as part of the contractual agreement.
o The investors cannot be forced to pay more than the capital they contributed
• Monotonicity (anti-sabotage)
o The investor’s payoff is weakly increasing in the payoff of the firm’s assets
o The value of the investors’ holdings can never decrease when the value of the firm’s assets increase
o Example: suppose the investors gets 1m when firm payoffs are 1m, but only 500k when firm payoffs are 2m. The investors would want to sabotage the project

Question 31

What does the Peking Order say?

Answer 31

Firms should issue securities in order of information sensitivity from least to greatest. Often times, the ordering is Cash  Debt  Equity

Question 32

Describe a scenario in which un-levered equity would be the optimal financial security for a firm to issue to raising financing (You can base your description on the Compensation Game if it helps).

Answer 32

Un-levered equity is the optimal security when the distribution of payoffs is unknown, but the expected value of payoffs is known. If the above holds true, then equity is the only compensation contract that guarantees incentive compatibility regardless of the structure of payoff since the owners receive the same share of payoffs in all possible outcomes.

Question 33

Describe a scenario in which debt would be the optimal financial security for a firm to issue to raising financing (You can base your description on the Audit Game if it helps).

Answer 33

Debt will be ideal to issue when payoffs are guaranteed cover the repayment of a risk-free loan, since such a scenario would allow a firm to take on a risk-free loan, i.e. the cheapest possible financing. Additionally, when there is costly state verification/audit costs debt is optimal. When the amount promised to investors (debt holders) is expected to be covered in all outcomes, there is no incentive for the company to misreport any amount that is higher than the constant promised amount. Because of that, there is no need to audit reports by the company above that amount, making debt the cheapest alternative.

Question 34

The use of debt as a financing tool provides many advantages. It lowers audit costs and is less sensitive to information about the expected payoff of a project than equity is. However, the use of debt distorts the incentives of management (who are aligned with the firm’s owners) and may result in risk-shifting. What are some contractual designs of debt contacts that help mitigate risk shifting (name at least two).

Answer 34

Using covenants which are clauses in a debt contract that place restrictions on what actions the debtor can take e.g.: limit the paying of dividends, limit the issue of new (senior) debts, limit investments, stipulate cash holdings or by using different security design such as convertible bonds

Question 35

What does the matching principle say? What trade-offs does the principle attempt to balance?

Answer 35

States that the short-term needs should be financed with short-term debt and long-term needs should be funded with long-term sources of funds.
The trade-offs the principle attempt to balance is:
• In general, short-term financial securities are less sensitive to the management’s information or actions than are long-term ones  short-term financing tends to be cheaper
• However, using short-term financing increases the risk of financial distress (i.e. funding risk)

Question 36

Describe how trade credit can be used as competitive advantage by financially stronger firms.

Answer 36

Trade credit can be used by financially stronger firms to make their bids more advantageous to the clients. Since paying later rather than sooner involves, for instance, saving the time-value of money for the client, clients will prefer to do so, all else equal. Therefore, firms with stable cash flows can make their bids more attractive by offering trade credit.

Question 37

Describe some advantages (at least 3) that suppliers may enjoy as a lender vis-à-vis traditional banks (3 points).

Answer 37

Suppliers may be better at liquidating assets in the event of a bankruptcy because they work in related industries.
Suppliers may have better information about the credit worthiness of the borrower because of on-going business relationships.
Suppliers may be better at enforcing repayment by threatening to sever future business ties.
Suppliers lend in kind, rather than in cash; the cost of the good/services may be significantly below market price.

Question 38

Describe some non-financing reasons for a firm to extend trade credit.

Answer 38

Non-financing reasons for a firm to extend trade credit includes:
• Customers may want time to inspect the quality of the goods
• Deferring payment makes ending a business relationship with customers more costly to the firm and may mitigate moral hazard
• Allows the firm to determine the willingness/ability to pay of its customers

Question 39

Describe some ways in which FinTech can provide value (name at least 3)

Answer 39

Taxes: Software and apps help consumers optimize deductions (TurboTax, H&R Block etc.)
Transaction costs: Payment apps, FinTech lenders process applications 20% faster
Information Asymmetry: Big data (such as real-time transactions and satellite images of traffic in the parking lot of big-box stores) lowers the information asymmetry between managers and investors

Question 40

Describe a situation in which tokens may serve as a superior financing tool compared to traditional financial securities.

Answer 40

A moral hazard problem, enables a more flexible contracting arrangements which allows it mitigate the moral hazard problem at the heart of its financial constraints
If a firm faces a moral hazard problem that is so great that the firm cannot be financed with any conventional financial security, i.e. a contract based on the free cash flow of the firm, tokens can be used to create a contract that adjusts what current owners get to keep for different outcomes. The coins then allow flexible contracting which mitigates the moral hazard problem