Finals Study

Question 1

MM setup returns on trade

Answer 1

R=(S_B+D)/S_A\alpha*x-\alpha(1+r_f)D-\alpha(x-(1+r_f)D)

Question 2

MM assumptions

Answer 2

no taxes, bankruptcy, t-costs, asymm. info, agency conflict, two period, identical firm

Question 3

What is ROE for MM

Answer 3

return on unlevered equity + debt / share ratio * risk premium (rho-r_f).

Question 4

Stiglitz and Miller result

Answer 4

Using account, GE implies that if financing decisions are changed, consumption and prices remain constant. Allows firms to be borrowing and lending at the same rate, no bankruptcy as well.

Question 5

Implication of Stiglitz and Miller

Answer 5

information asymmetry, commitment, agency has to be the solution for standard preferences

Question 6

Tradeoff Theory

Answer 6

Debt creates net tax benefit but also default costs.

Question 7

What is the tax shield benefit (equity, corporate tax, and interest rate tax)

Answer 7

\Delta = (1-(1-t_c)(1-t_e)/(1-t_i))

Question 8

5 conditions for signaling equilibrium

Answer 8

1. IR constraint; 2. IC constraint; 3. PBE RE; 4. Reasonable beliefs OEP; 5. Each type different inference

Question 9

Ross setup (2 type)

Answer 9

M=(1+r_f)\gamma_0V_0+\gamma_1[v_1-1_{v

Question 10

Ross 2 type solution

Answer 10

High type issues debt because it’s cheaper. Firm b issues 0 debt, provided cost of default is high enough. Cutoff F^*.

Question 11

Cont. Type Ross Model Setup

Answer 11

Type determines upper bound on the support of project type.

Question 12

Cont. Type Ross Model Utility

Answer 12

\gamma_0 a(F)/2+gamma_1(t/2-LF/t) if F

Question 13

Ross REE definition

Answer 13

a(F(t))=t

Question 14

Ross REE brute force solution (separating) steps

Answer 14

Steps:

1) Get DE using FOC within default probability region. Use appropriate boundary conditions.
2) Show equilibrium cannot have default for sure. Get corresponding parameters.
3) Never optimal to deviate to debt region (get parameters).

Question 15

Ross cont. pooling steps

Answer 15

conjecture a debt level (0) and check the IC constraints

Question 16

Intuitive criterion definition

Answer 16

OTP beliefs are zero for a type that does not benefit from deviation. Benefiting from deviation must be that the types inference is kept constant in the new setting.

Question 17

What does intuitive criterion rule out?

Answer 17

Pooling disappears. Only the most efficient separating equilibrium remains.
In efficient separating equilibrium, high type deviates epsilon lower and gains from issuing less debt. Since it is still not profitable for the low type to deviate, high type gets inference with probability 1 and remains well off.

Question 18

What does intuitive criterion rule out?

Answer 18

Pooling disappears. Only the most efficient separating equilibrium remains.
In efficient separating equilibrium, high type deviates epsilon lower and gains from issuing less debt. Since it is still not profitable for the low type to deviate, high type gets inference with probability 1 and remains well off.
It is key that the low type never gains.

Question 19

Write down the four conditions for Mailath

Answer 19

IC, SIC (equality for IC), SM (U_3/U_2 monotonic in type), IV (outcome when take the choice of the worst type, given everyone knows your outcome, important restriction)

Question 20

Additional restrictions for Mailath (5)

Answer 20

1) U is twice differentiable, 2) U_2\neq 0; 3) U_13\neq0; 4) worst type full information decision defined; 5) U_33>0.

Question 21

Mailath Theorem 1 and 2

Answer 21

dt/da = -U_2/U_3 if it exists. t is the menue that maps types to actions.
Doesn’t imply existence.

Question 22

Mailath: sign of t’?

Answer 22

Same as U_13

Question 23

Mailath Theorem 3

Answer 23

A menu satisfies SIC iff 1) the menu satisfies the DE (T1 and 2); 2) If U_2>0, then U_3 / U_2 is a strictly increasing function of type for the graph of the menu.

Question 24

Leland and Pyle Model Purpose

Answer 24

Equity can also be signal for project quality–firms want to own more of their project all else equal.

Question 25

Leland and Pyle W_0

Answer 25

W_0+D+(1-\alpha)(V(alpha)-D)-K-beta V_m-Y=0

Question 26

Leland and Pyle W_1

Answer 26

W_1=alpha[\tilde x+mu-(1+r_f)D)+beta\tilde M + (1+r_f)Y

Question 27

Leland and Pyle Combined BC

Answer 27

W_1 = alpha[\tilde x+m-mu(alpha)+lambda]+beta[\tilde m-(1+r_f)V_m]+(W_0-K)(1+r_f)+mu(alpha)-lambda

Question 28

LP Util

Answer 28

Mean variance with risk aversion b.

Question 29

LP Util

Answer 29

Mean variance with risk aversion b.

Question 30

Myers and Majluf Setting

Answer 30

Ownership dynamics, prioritize old shareholders. Trade off equity dilution against positive NPV projects.

Question 31

Myers and Majluf utility before and after investment

Answer 31

a+S vs P’/(P’+E)[(E+S)+a+b]

Question 32

Simpler version of Myers and Majluf (who invests?)

Answer 32

two types, no uncertainty regarding outcome, S=0. Only low type invests (opposite of Leland and Pyle)

Question 33

What is the price under Myers and Majluf

Answer 33

P=value of firm post investment - I

Question 34

Pecking Order

Answer 34

Second argument of Myers and Majluf. Funding should be in the order of cash, riskless bonds, risky bonds, then equities.
Markets fear adverse selection.

Question 35

Miller and Rock Setup

Answer 35

Two periods, x_1=F(I_0)+epsilon_1 and x_2=F(I_1)+epsilon_2 where I_1=x_1-D the dividend.

E[epsilon_2\midepsilon_1]=gamma_1epsilon_1

Util = kV_1(D)+(1-k)(D+1/(1+i)[F(F(I_0)+epsilon_1-D)+gamma\epsilon_1])

where V_1(D)=D+1/(1+i)[F(F(I_0)+\hat epsilon_1(D)-D)+gamma\hat\epsilon_1 (D)]

Question 36

Miller and Rock Solution

Answer 36

U_13=(1-k)f_12(D,\theta) is the sign where f is the production function.

Question 37

Jensen and Meckling two conflicts

Answer 37

Managers and shareholders: managers underproduce effort relative to entrepreneur

Debtholders and Equity holders: equity is an option which reduces the value of debt, which is conservative.

Question 38

Myers Debt Overhang

Answer 38

Excessive debt distorts managers incentives to take on efficient projects, since the returns are only accrued by the shareholders (when amt outstanding is suff. high)

Question 39

Jensen and Grossman and Hart

Answer 39

Empire building, debt reigns in excessive investment.

Question 40

Write down Brander and Lewis assumptions (for R)

Answer 40

R_ii<0, R_j<0, R_Z>0, R_ij<0, and R_iz\neq0

Question 41

Write down Brander and Lewis assumptions (for V)

Answer 41

V_ii<0, V_ij<0, V^i_iiV^j_jj-V^i_ijV^j_ji>0

Question 42

Townsend, Gale, and Hellwig CSV idea

Answer 42

optimal TT mechanism with commitment which raises funding for a project.

Question 43

Townsend, Gale, and Hellwig CSV idea

Answer 43

optimal TT mechanism with commitment which raises funding for a project.

Question 44

sketch the proof for the optimal mech

Answer 44

remember iff, have to prove in both directions.

1) Assume feasibility, then in default region pays constant; in verification, pay less than constant otherwise would be worse off.
2) second and third are sufficient for IC.

Question 45

Diamond Banking Setup

Answer 45

I=1, risky outcome, E[y]\geq R+K. What is the optimal p(s) and s(y) such that s(y)\leq y

Question 46

Write down Diamond max problem

Answer 46

max_p,s E[y-s(y)-p(y)]
s(y)\leq y
y\in arg\min(p(x)+s(x))
E[s(y)]\geqR

Question 47

what are the five observations in Diamond’s banking paper.

Answer 47

1) BE holds tight

2) c(y)=s(y)+p(y) must be weakly decreasing, and there exists a point at which c(y)D and c(y)>D for all y

Question 48

Why do intermediary costs fall?

Answer 48

Monitoring costs fall when aggregated–likelihood of default lowers so lower cost.