Lecture 1: Objective of Financial Reports

Question 1

Objectives of financial reports

Answer 1

Valuation

Stewardship

Question 2

What is information asymmetry?

Answer 2

Information asymmetry occurs when an imbalance in information knowledge between two participants in a given transaction.
- One party will have an information advantage.

Come in the form of adverse selection and moral hazard.

Question 3

What is adverse selection?

What objective does it contravene?

What are 2 key identifiers?

Answer 3

The perceptual belief that one party has hidden information regarding the true underlying value of the firm and if not disclosed can lead to incorrect allocation of resources.

Objective: Valuation

• Pre-transaction
• Hidden information about underlying economic value of the firm.

Question 4

Why would a manger issue and IPO at an inflated price?

Answer 4

Management issues IPO – potential investors know that management knows more information.

-	Managers have incentive to inflate price 
o	Existing share $10 
	Firm issues $10  Wealth 20/2 = $10
	Firm issues $8  Wealth 18/2 = $9
	Firm issues $12  Wealth 22/2 = $11

Question 5

3 key consequences of adverse selection:

Answer 5

1. Information disadvantage
   - increased information risk
   - Higher information risk  Higher cost of capital  lower share price  less capital raised.
   - Managers and investors  managers will only IPO when issue>fundamental value  investors will discount the price.
2. Greater Bid Ask Spread
   - Greater disparity between prices asked by buyers and prices offered by sellers.
   - Leads to lower liquidity (no convergence on prices)
   - Increase cost of capital (requires a premium to turn into cash)
   o Buyers or sellers price protect themselves (don’t want to lose on trade with better informed counterparties)
3. Share price no longer an accurate measure of underlying economic value –> inaccurate resource allocation occurs.

Question 6

How to mitigate adverse selection?

Answer 6

1. Greater mandatory disclosure
2. Voluntary disclosure
3. Other information intermediaries (e.g. media, financial analysts)
4. Older stocks will have less bid ask spread  more opportunity to know the company.

Question 7

What is Moral Hazard?

2 key examples:

What objective does it relate to?

Answer 7

Due to separation of ownership and control, only one party can see their fulfilment of the contract, therefore leading to hidden actions.

1. Debt
2. Current and potential shareholders.

Efficient contracting or stewardship objective

Question 8

What are 4 actions of moral hazard?

Answer 8

Actions:

1. Shirk (neglect responsibility to the company)
2. Pay perks unrelated to firm performance.
3. Dividend retention and empire building
4. Risk Aversion (safe projects, not taking all pos. NPV projects)

Ultimate consequence, undermining shareholder wealth.

Question 9

How to mitigate?

Answer 9

Efficient contracting:

Shareholders – management incentive schemes
Lending contracts – leverage limits and debt covenants.

Question 10

Comparing Adverse Selection and Moral Hazard.

Answer 10

Both are consequences of information asymmetry.

Adverse selection is pre transaction, moral hazard is post.

Question 11

4 actions of moral hazard on Debt

Answer 11

1. Excessive dividend payments
   a. Take out loans to pay it out as dividends – firm goes bankrupt
   i. Shareholders are protected by limited liability
2. Asset substitution:
   a. Move to riskier assets
   i. Cash  investment
   ii. Risk incurred by debt holders (who don’t receive any benefit)
3. Claim dilution
   a. Leverage up – i.e. more debt
   b. Lenders exposed to excess risk
4. Under investment
   a. If a project is only going to generate cash and the firm is going into liquidation, the firm has no incentive to enact said investment  as excess cash will be distributed to debtors.

Question 12

Excessive dividend payments

Answer 12

Take out loans to pay it out as dividends – firm goes bankrupt
i. Shareholders are protected by limited liability

Question 13

Asset substitution:

Answer 13

a. Move to riskier assets
i. Cash  investment
ii. Risk incurred by debt holders (who don’t receive any benefit)

Question 14

Claim dilution

Answer 14

a. Leverage up – i.e. more debt

b. Lenders exposed to excess risk

Question 15

Under investment

Answer 15

a. If a project is only going to generate cash and the firm is going into liquidation, the firm has no incentive to enact said investment  as excess cash will be distributed to debtors.

Question 16

Fundamental issues with financial statements

Answer 16

S/H want conservative approach.

Management could say conservatism does not accurately reflect performance.

Question 17

Why do lenders demand conservative accounting?

Answer 17

• Payoff asymmetry (i.e. don’t receive the benefit when the firm is successful but bears the cost when the firm performs poorly).
• Conservatism (e.g. unrealised losses) could act as an early warning of financial distress.
• Limit dividend

Question 18

Why do shareholders demand conservative accounting?

Answer 18

• Managers are assumed to act in their own self-interest (not the interest of shareholders)
• Timely recognition of negative NPV projects
• Shareholders demand conservatism to limit opportunistic actions.

Question 19

5 reasons why debt costs less than equity

Answer 19

1. Nominal face values (payoffs) are known  therefore lowers information asymmetry.
2. Equity: IPO (incentive to inflate)
3. Debt: disciplinary -> decrease moral hazard
4. Interest Tax Deductible
5. Debt: access to internal information.