Lent Term - Lecture 5 Flashcards
What is the pecking order of financing?
Cash/retained earnings > Debt > Equity
What does empirical evidence show about the amount of equity raised yearly?
It is usually negative because money is paid out to shareholders
What would issuing firms’ insiders have superior information about?
- Prospects of the investment project
- Value of pledged collateral
- Value of existing assets
When there is asymmetric information what causes under and over-investment?
If the average firm has an NPV that is negative then there is under-investment. If the average firm has a positive NPV then there is over-investment.
Why does under-investment happen?
Bad firms act like good firms and so on average, investors receive less than they are supposed to so they do not invest
What is Akerlof’s lemon problem?
Gains from trade may not materialise because of adverse selection. It explains underinvestment.
In what case is some over-investment okay?
In cases of pooling where there are more good firms than bad firms. Good firms are financed at a discount while bad firms are financed at a premium.
Does the pooling equilibrium always imply over-onvestment?
No, as long as the bad firms have positive NPV projects it is not over-investment. The presence of the bad firms hurts the profits of the good ones but all positive NPV projects get funded.
