Financing Aspects of Investments Flashcards
With reference to investment in R&D, which are the financing alternatives for big firms and SMEs?
•Small and large firms can both finance their activity through internal profits generated by the firm ´ s activity or external capital i e debt or equity
Pecking Order
•Pecking order theory suggests internal capital should be used first, followed by borrowed capital and equity, in practice this is not always possible
• The pecking order theory can be more easily applied to mature and bigger companies Modigliani Miller theorem )
• Young and small firms might not have profits to reinvest solution: giving out some of the control to venture capital or private equity companies
Pros/Cons
• Considering pros and cons of financing through debt: despite the bankruptcy costs , debt might appear more convenient if it is deductible (absetzbar)
•Considering pros and cons of financing through equity , this does not require neither any collateral nor the payment of interests but involve giving out part of the ownership power
Which problems might arise in dealing with external financing?
• Incentive problem : results from asymmetric information (e.g. hidden information and hidden
actions) between the firm ´ s owner/manager on the one side, and financial institutions/shareholders on the other.
In particular, if the entrepreneur/manager is insured against the risk of failure typical of an R&D project, he might overinvest in R&D and/or not put the adequate effort into the project.
• Short termism : when capital markets put more emphasis on the short rather than the long run, firm ´ s owners(=investors) but also managers do everything possible to increase profits in the short run taking management decision that might compromise future cash flows.
A problem which notably lead to underinvestment in R&D, the latter being intrinsically long
term.
important:
- incentive problems and short-termism are more likely to take place when firms´ ownership and control are separated (i.e. in the case of large firms on by several stakeholders and controlled by a manager).
- linked to the external financing there is also agency costs, i.e. managerial incentive to acquire capital for safe projects and invest it in riskier projects instead (asset substitution).
With reference to managerially led firms, in what do the principal agent and free rider problems consist?
- arises from managers and shareholders having different interests at stake
- > by the presence of hidden information
- > hidden actions resulting in adverse selection and moral hazard, respectively.
In order to overcome this problem, a set of actions can be undertaken:
i. design adequate incentive scheme: a fixed salary is paid to the manager but a part of the compensation is made contingent on the observable output
ii. shareholders can implement monitoring to make sure that managers put the appropriate level of effort in maximizing profits
monitoring is not always easy to implement and comes at a cost.
iii. follow the insights provided by signalling models to identify good and bad managers
What do we mean by “venture capital”, “equity”, “private equity” and “business angels”?
- Equity: ownership of a company through shares of stock held by investors. Income stream is random and risky.
- Private equity : equity in companies not traded on the stock
- Venture capital: provision of equity for young, unquoted companies at an early stage showing high growth potential and commercial uncertainty. The key feature is the “hands on” involvement by the finance provider.
- Business angel: private individual investing part of his personal assets in a start up and also sharing his personal management experience with the entrepreneur.
- Debt: bonds that guarantee the investor a stream fixed interest payments as well as the repayment of the principal (=the sum initially lent by the investor).
Which accounting principles could be employed by a company to register investments in R&D in the balance sheet?
- By looking at the balance sheet we see all the elements composing the assets (revenue + investments, active side) and liabilities (expenditure, passive side) in one financial year.
- The difference between assets and liabilities: equity (capital, revenue distributed to the shareholders as dividends as well as the capital reinvested in the economic activity).
- R&D is registered on the active side under the voice “ Intangible assets ” and on the passive side as an expenditure on R&D. Accountant’s practice should avoid two potentially severe distortions:
(i) Inclusion of an asset in the balance sheet of extremely uncertain worth and
(ii) Over statement of reported profit (which could in theory be distributed to shareholders
• According to the principle of prudence all expenditures in R&D undertaken in a specific
year should be registered in the same time period in which they take place, regardless of when the positive (and uncertain) cash flow will happen. Because the balance sheet has to “balance” every year, on the asset side this transaction will appear as a “noncurrent assets”.
• According to the matching principle , the transaction (expenditure on R&D) should be registered as a liability in the same year in which the positive cash flow takes place.
What is the aim of this paper?
Aghion P., Bond S., Klemm A., Marinescu I. (2004). Technology and financial structure: Are
innovative firms different? Journal of European Economic Association, 2(2
- to investigate whether financing choices differ across firms by R&D intensity
- to looking at a balance sheet measure of the debt/assets ratio to consider the probability
of raising finance by issuing new equity, and the shares of bank debt and secured debt in
total debt
The sample consists of 900 British companies (in the manufacturing, construction and extraction industries) whose shares are listed on the London Stock Exchange.
Across these companies, data on R&D expenditure have been collected over the period 1990 2002, giving rise to an unbalanced panel dataset.
What theoretical concepts can be used to explain the financial choices of innovative firms?
Aghion P., Bond S., Klemm A., Marinescu I. (2004). Technology and financial structure: Are
innovative firms different? Journal of European Economic Association, 2(2
Bankruptcy costs
• Refer to an increase in the cost of financing with debt relative to the cost of financing with equity that results from a higher probability of bankruptcy.
• Bankruptcy costs are likely to be higher for innovative firms with a bigger proportion of intangible assets, which might explain why such firms are less reliant on debt finance.
• The rationale behind it is the following:
- financing with debt increases the probability of an innovative firm to go bankrupt
- A higher risk of bankruptcy , in turn, increases the cost of financing with debt
Agency costs and information asymmetries
•The principal agent model rises from information asymmetries between the manager controlling the firm and investors owning it.
•When managers dispose of more information about firm ´s financial prospects than investors, they will issue new equity if they think that in the future the firm will underperform .
•As a result, the new shares issued will be under priced , which creates a dilution cost on the firm ´s initial owners .
•The higher the degree of information asymmetry, the higher the dilution costs. It is reasonable to believe that more innovative firms offer more attractive investment opportunities and are also more in need of external capital than less innovative firms.
Control rights (in alternative to pecking order) • When the level of assets is low , outside investors will try to exert as much control as possible on the firm ´s decision in order to avoid losses. Knowing that, managers will try first to finance their projects through internal funds but then they will ask for new debt because debt financing allows them to retain control for themselves as long as the firm does not default. • However, more innovative firms have more attractive investment opportunities but also more intangible assets (than less innovative firms) and will therefore tend to rely more on new equity than debt.
What are the main results?
Aghion P., Bond S., Klemm A., Marinescu I. (2004). Technology and financial structure: Are
innovative firms different? Journal of European Economic Association, 2(2
- R&D has a positive and significant impact on debt/assets ratio
- Firms investing in R&D report a higher probability of issuing new equity than firms who do not.
- The composition of debt (dependent variables are share of bank debt/total debt and share of unsecured debt/total debt)
Which theory is supported by these empirical findings?
Aghion P., Bond S., Klemm A., Marinescu I. (2004). Technology and financial structure: Are
innovative firms different? Journal of European Economic Association, 2(2
- The overall picture is in support of the control rights approach and also the pecking order effect since the probability of issuing new equity is positively affected by the intensity of investment in R&D
- Results do not provide evidence for the presence of information asymmetry and dilution costs; in fact, extensive use of new equity among innovative firms suggest that dilution costs are absent (which does not make equity finance particularly expensive
- For what concerns the composition of debt , innovative firms get indebted the most with financial institutions other than banks and with a higher share of unsecured debt (=not secured by any underlying asset
