Final exam

Question 1

Modigliani and Miller (1958)

Answer 1

• The market value of any firm is independent of its capital structure.
• Return on equity is endogenous in leverage.

Question 2

Miller (1977)

Answer 2

• Personal taxes impact the value of the debt tax shield
• Clientele effects due to progressive tax rates. Eq’m. such that firms have 0 marginal DTS and benefits go to investors in low tax bracket

Question 3

Myers (1977)

Answer 3

• Debt overhang causes underinvestment to occur
• Solutions: Pari-pass debt (though note it creates asset substitution problem). Covenants can fix asset substitution, but then exacerbate debt overhang.

Question 4

Diamond and He (2014)

Answer 4

• Short-term debt has lower debt overhang

Question 5

Jensen and Meckling (1976)

Answer 5

• Debt can result in asset substitution because equity holders only care bout the upside as they are not exposed to downside risk

Question 6

Townsend (1979)

Answer 6

• Costly state verification results in debt still being the optimal contract, but inefficient underinvestment relating to auditing costs
• CSV requires upfront commitment

Question 7

Innes (1990)

Answer 7

• Debt contract is optimal when agent has limited liability and contract is monotone in profits

Question 8

Zwiebel (1996)

Answer 8

• Entrenched managers issue debt as a defensive device to commit sufficient value when their empire building is threaten by potential takeover and dismissal
• Middle quality managers lever up to fend off takeover

Question 9

Holmstrom and Milgrom (1987)

Answer 9

• Optimal management compensation contract is linear (e.g., fixed + variable) in dynamic model with CARA utility

Question 10

Gabaix and Landier (2008)

Answer 10

• Small dispersion in CEO talent but large dispersion in CEO pay explained by firm size and outside options (best managers paired w/ large firms)

Question 11

Leland and Pyle (1977)

Answer 11

• Entrepreneur’s willingness to invest in his own project can serve as a signal of project quality under information asymmetry
• Set of investment projects that are undertaken coincides with the set that would be undertaken if direct information transfer were possible
• Application to IPO setting -> IPO price should be lower if offering share is greater

Question 12

He (2009)

Answer 12

• Extension of Leland and Pyle to multiple correlated assets

- Assets are interconnected, and so cross-signaling can occur and be cross-informative

Question 13

Myers and Majluf (1984)

Answer 13

• Managers’ interests aligned with those of “old” shareholders, and may not issue new stock for positive NPV projects because of costs to old shared holders of issuing shares at bargain price
• Financial slack has value because firm is sometimes unwilling to issue stock and passes up a good investment opportunity
• Lemon problem with securities: asymmetric info affects capital structure of firm and preference for internal to external financing
• Pecking order theory: firms first take internal earnings, then debt, then equity

Question 14

Rock (1986)

Answer 14

• Explains underpricing of IPOs
• When there are informed and uninformed investors and an IPO may be oversubscribed, the uninformed investors suffer from winner’s curse
• Therefore, equilibrium IPO pricing must include a discount to attract uninformed investors

Question 15

DeMarzo and Duffie (1999)

Answer 15

• Firms want to exchange claims to cash flows for cash, and have private info on the cash flows
• This leads to an adverse selection problem because firms with high cash flows issue debt and low cash flows issue equity (therefore, equity issuances are a negative signal)
• Tradeoff between illiquidity costs (lowering price to sell equity) and retention costs (having to hold on to more assets) results in an optimal contract of risky debt
• A debt contract has the lowest sensitivity to the seller’s private information

Question 16

Kyle (1985)

Answer 16

• 3 types of traders: insiders (with market power), noise traders, and market makers (set price based on total order flow, break even)
• Half of the information of the informed trader gets incorporated into the price (more noise trading reduces informative ness but encourages insider to trade more aggressively)
• Kyle’s Lambda is a measure of illiquidity of financial markets (captures price impact - how much a price moves with the order flow)
• Noise traders are a requirement for the model

Question 17

Hart (1995)

Answer 17

• Discussion of hold-up problem where relationship-specific investment leads to underinvestment
• Ownership matters because of residual control rights (especially when contracts are incomplete)

Question 18

Aghion and Bolton (1992)

Answer 18

• Entrepreneurs raise capital from investors; E choose action; E has additional nonpecuniary benefits in addition to profits
• Efficient to give E as much control as possible subject to I breaking even
• Existence of ex ante inefficiency (not raising enough money) and ex post inefficiency (incorrect action taken by E)
• State-contingent control (think of it as debt with covenants) allocated control to people who will do the efficient thing in the right states

Question 19

Diamond (1991 QJE)

Answer 19

• Good types trade off the change to refinance at a lower rate against liquidity risk (loss of control rent)
• Good types prefer short-term to get better refinancing later and bad firms prefer long-term to lock in rate now before bad news
• Short term debt makes firms more sensitive to new information, but exposes firms to loss of control rents

Question 20

Diamond (1991 JPE)

Answer 20

• Reputation effects are important for dealing with moral hazard
• For older firms, reputation becomes an asset that means they no longer need monitoring

Question 21

Rajan (1992)

Answer 21

• difference between public & private debt is interim information
• ST private debt - liquidation can occur at interim, renegotiation occurs for good signal, higher agent bargaining power -> larger bonus for good performance
• LT public debt - not enough incentives, too low effort
• LT private debt - lower reward and softer penalty relative to first-best -> effort too low; renegotiation for bad signal - higher bargaining power -> lower penalty for bad performance

Question 22

Petersen and Rajan (1995)

Answer 22

• Credit market competition may reduce the availability of credit
• Banks in monopolistic credit markets finance firms of lower credit quality (can subsidize distressed firms)
• Interest rate charged to younger or lowest quality firms will be lower in a concentrated market (banks can get surplus later, whereas in competitive market, have to charge higher rate upfront since firms can switch banks)

Question 23

Bolton and Scharfstein (1990)

Answer 23

• Investors/banks want to strengthen financial constraints to avoid adverse selection problems, but weaken them to avoid predation from competitors in interim periods (where inefficient liquidation could occur if interim bad performance)

Question 24

Bolton and Scharfstein (1996)

Answer 24

• Borrowing from many creditors can cause loss in liquidation value, but can also deter strategic default (“hard” budget constraints)
• Strategic default consideration favors multiple creditors; liquidation default consideration favors one creditor
• Low default risk borrowers -> public debt, high default risk -> bank debt

Question 25

Diamond (1984)

Answer 25

• Banks can diversify their assets, which eliminates the issue of “monitoring the monitor”
• Instead of monitoring the bank, the bank’s depositors can have a debt contract with penalty (b/c of diversification penalty will never be paid and therefore won’t be any DWL)

Question 26

DeMarzo (2005)

Answer 26

• Pooling of assets results in an information destruction effect (destruction of agent’s private information), but also a risk diversification effect (less sensitive to private info, makes senior claim lower risk)
• As pool grows larger, diversification effect dominates
• Pooling is optimal when uninformed sells to informed; tranching/retention is optimal when informed sells to uninformed

Question 27

Diamond and Dybvig (1983)

Answer 27

• Banks play a role of consumption smoothers between early and late types; they provide liquidity in a world of incomplete contracts
• Providing this liquidity comes with a cost - a bad equilibrium is a bank run
• Possible solutions: suspension of convertibility, deposit insurance

Question 28

Calomiris and Kahn (1991)

Answer 28

• Answers question of why bank finances itself with demand able deposits - it provides an incentive scheme for investors to monitor the bank, also justifies the first-come, first-served scheme
• Kind of weird since the bank run “rewards” those depositors who have monitored vs. those who haven’t (sleepy investors)

Question 29

Holmstrom and Tirole (1997)

Answer 29

• Looks at effects of capital tightening across households, firms, and intermediaries
• The scarcer intermediary capital, the greater the rent they can extract given everyone else is capital constrained
• Look at how levels of investment, interest rates, and intensity of monitoring change across various credit crunch scenarios

Question 30

Holmstrom and Tirole (1998)

Answer 30

• Firms have projects with liquidity shocks - they can either store their own cash (which is inefficient) or can have lines of credit from banks (works for banks because they hold collateral)
• Liquidity shock comes from assets-side of the bank (previously looked at liabilities-side only).

Question 31

Diamond and Rajan (2001)

Answer 31

• Relationship lender has specialized knowledge about borrower that allows him to better collect, but the lender may be subject to liquidity shocks
• The loan can become illiquid and inefficiently liquidated because of lower market value to outside lenders
• Lender can’t credibly commit to collect, so instead commits by issuing demandable deposits (it’s a commitment because of the threat of a bank run)
• Banker is useful not because he creates value, but because he affects the transfer between the borrower and the depositors

Question 32

Dang et al. (2017)

Answer 32

• Banks as secret keepers
• Banks observe information to screen out lemons, but does not disclose anything to the public — results in efficient allocation of capital and no information that can cause “early volatility”
• Banks create safe assets through inter temporal substitution of good and bad periods, which creates liquidity insurance
• Maria note: kind of like a socially good Ponzi scheme

Question 33

Diamond (2020)

Answer 33

• General equilibrium of how the financial system is organized to most efficiently create safe assets
• Riskless assets provide “liquidity serves” that households want, while firms face an agency problem increasing in their size
• Explains:
  1) why intermediaries invest in debt while households invest in equity
  2) why intermediary leverage is high while non-financial firm leverage is low
  3) how risk is priced in endogenously segmented debt and equity markets

Question 34

Bernadette and Gertler (1989)

Answer 34

• Balance sheet channel (positive shock makes borrower wealthier -> increased net worth -> easier to get financing -> more efficient investment -> gets richer -> … )
• Overlapping generations model where entrepreneurs have labor income and can also borrow from households to invest
• Agency costs of undertaking physical investments are inversely related to entrepreneur’s net worth - produces the financial accelerator effect

Question 35

Shleifer and Vishny (1992)

Answer 35

• Fire sales - require a 1) distressed seller, 2) distress due to industry-wide shock, and 3) heterogeneity among buyers (insiders/outsiders with differences in how productive they can be with the asset)
• Debt has benefit of preventing inefficient investment, but comes with the cost of more frequent costly liquidation

Question 36

Shleifer and Vishny (1997)

Answer 36

• Noise traders impose limits to arbitrage
• Trader facing a leverage constraint may need to liquidate at bad prices in the interim
• No-arbitrage arguments require that you be able to keep the position for the duration. If there’s a risk you have to take off the position, it’s not really arbitrage

Question 37

Kiyotaki and Moore (1997)

Answer 37

• Small, temporary productivity shocks can generate large, persistent fluctuations in output and asset prices