Concepts Flashcards
Explain how adverse selection can lead to inefficient investment.
Investors realize that firms with bad projects have an incentive to not divulge that information, as a result a we have lemons market ala Akerlof (1970). Investors will assume that firms projects are of average quality and will offer a price reflecting such. Firms with good projects won’t accept the low prices and as a result there will be inefficiencies.
Myers and Majluf (1984) among others.
How does informational asymmetry relate to credit rationing
Credit rationing in equilibrium relates to adverse selection and moral hazard. Adverse selection stems from the fact that as interest rates rise the average riskiness of borrowers rises. Those willing to accept such high rates do so because they know the probabiliy of repayment is low. Moral hazard arisis because as interest rates rise project hurdle rates rise, pusing managers to take low probability but high payoff projects. Thus, there exists an point below the market clearing price which maximizes the bank’s profits and, then, credit is rationed.
**Jaffee and Russell (1976), Stiglitz and Weiss (1981, 1983), **
How do credit market frictions arise from debt overhang.
High leverage may discourge lenders from loaning funds to a firm, especially if the firm issues debt that is junior to existing debt. Because if the existing debt is trading below face value, any proceeds from new projects will go towards making the existing creditors whole, at the expense of those who funded the new project.
Myers (1977)
How does costly state verification affect corporate finance.
If we a assume a lender can only verifiy cash flows by paying some fixed auditing costs, then a standard debt contract wil arise. This is such that a firm must make a fixed payment R, otherwise an audit will be triggered and the assets seized. The lower the entrepreneur’s endowment the more he will need to borrow and the higher R will be, which increases the projects hurdle and thus the likelihood of incurring the auditing cost. This translates to less investment.
** Townsend (1979) and Gale and Hellwig (1985)**
How does incomplete contracting relate to debt and mangerial incentives?
More recently, following the work of Grossman and Hart (1986), Hart and Moore(1990), and Hart (1995) on incomplete contracting, the emphasis has shifted to thinking of financial contracts in terms of the allocation of control rights that they embody; debt is often seen as an incentive scheme that rewards management with continued control if it makes the required debt payments, and punishes it with loss of control otherwise. In a multi-period framework, this type of incentive scheme enables outside lenders to extract payments from managers even in the extreme case where cash flows are completely unverifiable. Well-known papers in this vein include Bolton and Scharfstein (1990) and Hart and Moore (1994, 1998).
How does debt mitigate empire-building by managers?
Jensen (1986, 1993) argues that empire-building preferences will cause managers to spend essentially all available funds on investment projects. This leads to the prediction that investment will be increasing in internal resources. It also implies that investment will decrease with leverage, because high current debt payments force cash out of the firm, thereby reducing managers’ discretionary budgets. Note that these are the same basic predictions that emerge from the costly-external-finance genre of models described in Section 2.1 above, though of course the welfare implications are very different
Explain how the hold out problem can lead to a failure of a distress exchange and how this problem can be mitigated.
Due to the Trust Indenture Act of 1939, there must be unanimous agreetment by bondholders to renegotiate the debt with firms. Distress exchanges get around the law by allowing nontendering bondholders to keep their orginal claims. The hold out problem surfaces because by the tendering bondholders accepting a loss in the value of their claims, they increase the value of the nontendering hondholders’ claims. Thus, their is an incentive to hold out making it difficult to complete an exchange.
This problem can be mitigated by offering a more senior security to those who tender, inducing the free riders to accept the exchange offer for fear of becoming junior to the new claims.
Gertner and Scharfstein (1991)
What private benefits may induce managers to diversify even if it reduces shareholder wealth?
Diversification may benefit managers because of the power and prestige associated with managing a larger firm (Jensen (1986), Stulz (1990)), because managerial compensation is related to firm size (Jensen and Murphy (1990)), because diversification reduces the risk of managers’ undiversified personal portfolios (Amihud and Lev (1981)), or because diversification helps make the manager indispensable to the firm (Shleifer and Vishny (1989)).
Denis, Denis and Sarin (1997)
Explain some of the benefits of diversification and how this may explain patterns over time.
One benefit is tied directly to the classic theory of the firm (Coase (1937) and Williamson (1971)). Firms may diversify because of more efficient internal capital markets. A second benefit is that information asymmetries between firms and investors (Myers and Majluf (1984)) can be diversified away because some segments have less at any given time. A third benefit may be a greater tax-shield. Diversification increases a firm’s debt capacity, because during bad states some segments assets will remain liquid (Schiefer and Vishny (1992). Other potential benefits include mergers using cash and mitigating the FCF problem of Jensen (1986); redepolyability of assets, such as labor (Tate and Yang (2011); or through monitoring efficiency ala Diamond (1984).
Some of the costs include agency and influence costs (Denis, Denis and Stulz (1994)); overinvestment in poorly perfoming segments at the expense of other segments (Lamont (1997)); difficulty in determining market value of segments. Forces such as reduced tick size and financial innovation (e.g. derivatives) have increased market liquidity and, thus, reduced informational asymmetries. Because of this the costs began to outweight the benefits to diversification in the 80s, which likely explains why firms became more focused in the 90s.
How does expensive external funding justify risk management (hedging)?
The basic logic can be understood as follows. If a firm does not hedge, there will be some variability in the cash flows generated by assets in place. Simple accounting implies that this variability in internal cash flow must result in either: (a) variability in the amount of money raised externally, or (b) variability in the amount of investment. Variability in investment will generally be undesirable, to the extent that there are diminishing marginal returns to investment (i.e., to the extent that output is a concave function of investment). If the supply of external finance were perfectly elastic, the optimal ex post solution would thus be to leave investment plans unaltered in the face of variations in internal cash flow, taking up all the slack by changing the quantity of outside money raised. Unfortunately, this approach no longer works well if the marginal cost of funds goes up with the amount raised externally. Now a shortfall in cash may be met with some increase in outside financing, but also some decrease in investment. Thus variability in cash flows now disturbs both investment and financing plans in a way that is costly to the firm. To the extent that hedging can reduce this variability in cash flows, it can increase the value of the firm.
Froot, Scharfstein and Stein (1993)
