L1: Introduction to Conceptual Frameworks - Moral Hazard Flashcards
What does a financial manager do?
How to get money from investors?
- Capital structure
- Short-term financing
- Long-term financing
What to do with the money?
- Risk analysis
- Valuation
- Project selection
How to return the money to investors?
- Payout policy
- Exit strategy
What are the assumptions of the M&M world?
- No taxes
- No transaction costs
- No agency problems
- No information asymmetry
- No externalities
What can we say about the financial manager’s work in the M&M world?
Easy! Financing decisions and payout decisions are irrelevant; Take on any and all projects with positive NPV!
However not the case in the real world.
What does Melnik, A., & Nissim, D. (2003) suggest about the size of floatation costs?
The fee paid (by the company) to an investment bank for floating a particular bond issue, expressed as a percentage of funds raised, is on average about 1% with a standard deviation of 50 basis points.
What is a decision tree and which components should it contain?
Maps out the possible actions that a decision maker can take at different stages.
- Decision nodes showing the choices available at each stage.
- Information nodes showing payoff relevant information to be learned (and their probabilities).
- Outcome nodes showing the payoff associated with particular paths.
When does a principal-agent relationship occur?
When one party (the principal) contracts with another (the agent) to take some action on their behalf.
What is a principal-agent problem (agency problem)?
When the agent is motivated to act in their own best interest (via a hidden action) to the detriment of the principal.
What are some common examples of agency problems?
- Employer (principal) and employee (agent)
- Shareholders and management
- Bank and borrower
- Citizens and politicians
- Insurer and policyholder
What is incentive compatibility?
A contract is incentive compatible if it motivates the agent to take actions according to the principal’s best interest.
Key idea: Make the agent’s payoffs contingent on events that are related to the agent’s hidden action / principal’s payoffs.
- If the agent’s payoff does not depend on the outcome of the task, the agent may pursue personal interests at the expense of the principal.
- Incentive compatibility involves aligning the interest of the agent with that of the principal (“skin in the game”).
What does Fields, L. P., Fraser, D. R., & Subrahmanyam, A. (2012) suggest about the link between board quality and the cost of debt?
- Firms that pay their CEOs more based on performance have lower cost of borrowing.
- High quality boards (experiences, diverse, independent) lowers the cost of borrowing, direct and indirect.
(boards are important for limiting the private benefits of the entrepreneur).
What does Schmalz, M. C., Sraer, D. A., & Thesmar, D. (2017) suggest about housing collateral and entrepreneurship (collateral and financing)?
- French administrative data
- Housing value as exogenous variation of collateral value. Treated group: “full” homeowners. Control group: renters and “partial” homeowners
- Those who receive positive collateral shock are more likely to start companies
- Conditional on starting a new company, those who receive positive collateral shocks borrow more and start larger companies.
Similar evidence:
- Evan and Jovanovic (1989): personal wealth
- Hurst and Lusardi (2004): inheritance
- SBA 7a Loan Program
Is there a link between wealth inequality and financing?
The fact that having access to some initial wealth increases company formation, greater company growth, and better financing shows that financing frictions are relevant. Moreover, this result suggests that wealth inequality, whether between societies or individuals in the same society, has an impact on future value-creating, real activities.
How are agency problems linked to financing?
- Agency problems can limit how much financing a firm can raise (not all NPV positive investments can be made).
- Agency problems can be partially overcome by paying managers based on firm performance (e.g. stock pay).
- A credible commitment to reduce the private benefits and increase monitoring can help relax the financial constraint (importance of corporate governance).
- Cash or equivalent collateral can help relax the financial constraint (payout policy and capital structure are not irrelevant).
What are two ways to mitigate agency problems?
- Incentive compatible contracts (incentive compatibility does not leave enough equity for investors).
- Good corporate governance.
Taxes can impact…
- capital structure - leverage (interest tax shield)
- Vertical integration instead of long supply chains
