LT WEEK 7

Question 1

Who’s payoff do managers aim to maximise

Answer 1

We always aim to maximise the payoff of old shareholders

Question 2

How do we decide whether to issue shares and do a project

Answer 2

• We look at what ownership of the company the old shareholders will retain and whether this is greater than doing nothing

Question 3

Alternatives to issuing shares

Answer 3

• use retained earnings
• Issue debt

Question 4

Pecking Order Theory

Answer 4

When firms finance projects they prefer to use least information sensitive securities first
* Cash
* risk free debt
* risky debt
* equity

Question 5

Agency Problem

Answer 5

Managers may be self interested and engage in negative NPV projects + exploit customers.
They only bear a small cost ( proportional to their ownership)
But they enjoy the full benefit.

t

Question 6

When will an entrepreneur choose to exert high effort (equity)

Answer 6

• This is when their payoff of high effort is greater than their payoff of low effort.
• We look at the value of the company with high/low effort and see what the manager retains

Question 7

When will a manager choose to work hard (Debt financing)

Answer 7

• Look at the payoff a manager gets after paying all debts in upstate and down state.
• See what level of debt should be issued for them to work hard

Question 8

Why might managers exert less effort under equity financing

Answer 8

The proportion of equity held by outsiders means fewer benefits accrue to managers

Question 9

Solutions to Agency Problem

Answer 9

• Dividends
• Debt
• Managers face the risk of being fired
• options ( giving managers options in the firm gives incentive to raise share price, as with positive payoff, you end up with more money.

Question 10

How to see how much equity owners demand

Answer 10

We equate the payoff of high effort x a=how much they provide.

If they provide 120 and the highest payoff is 160,
160a=120

Question 11

How to see how much debt holders demand

Answer 11

We equate the expected payoff of high effort for debt holders to how much they provide.

If it is 180 in upstate and 80 in down state and we provide 120-
(F)p + 80(1-p)=120

Question 12

What is the agency conflict between nmanagers and outside investors?

Answer 12

The greater the percentage that equity is held by outside equity, the less incentive managers have to exert full effort, hence lower value of firm. In order to generate value or grow value of firm, mangers must exert costly effort. The cost is borne onto managers, this is less likely to happen when financed by debt.

Question 13

What is the NPV of the project ?

Answer 13

Question 14

In exchange for providing 120, outside investors demand an equity stake α.
If outside investors believe the entrepreneur will choose to exert high effort, they break even if: then what how much will entrepreneur retain?

Answer 14

Question 15

But will the entrepreneur choose to work hard under these terms? what can we conclude?

Answer 15

Question 16

Lets look at debt financing now, lets say
Assuming the entrepreneur works hard, debt holders will demand a minimum face value F that? and when will entrepreneurs work hard?

Answer 16

Question 17

How do you calculate how many new shares to be issued?

also lets say question has a utility function right and it asks you to find minimum stake that maximises effort?

Answer 17

= amount needed to be raised / new share price.

What you do is that you do the stake retained multiplied by expected cash flow with high effort) - the disutility of working and set = 0.