Week 5 (6.1+6.2+6.3)

Question 1

Why is there no agency conflict with debt?

Answer 1

no agency conflict with debt: the owner/manager exerts high effort whenever it has higher NPV

Question 2

What is the Free Cash Flow Hypothesis in agency problem context?

Answer 2

Additional (informal) argument for why higher leverage reduces wasteful spending by managers
* Idea: wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed after making
all positive-N P Vinvestments and payments to debt holders.
* When cash is tight, managers will be motivated to run the firm efficiently ⇒ contrast to #4-2, Fallacy 5: Cash Hoarding!

Question 3

What implictions does adverse selection have for firm financial choices

Answer 3

Pecking order: to reduce adverse selection problems, firms may prefer to first issue the least-information sensitive securities
* Signaling: firms may engage in costly signaling (for example, posting collateral) to convince investors they are a good firm
* Equity issuance cost and market breakdowns: investors may perceive a firm announcing an equity issuance as over-valued,
resulting in a negative stock price response.
* Winner’s curse: IPOs tend to be underpriced because investors may be concerned about buying into a bad firm

Question 4

What is Adverse selection?

Answer 4

asymmetric information about the type of an individual/asset/firm/…

Question 5

What are limited partners in PE/VC?

Answer 5

hold shares in the VC firm but have limited voting rights
* Often institutional investors such as pension funds, insurance companies, mutual funds
* Investing in venture capital firms, limited partners benefit from diversification and the expertise of the general
partners in selecting firms

Question 6

What are General partners (GPs): in PE/VC?

Answer 6

managers of the VC firm (“Venture capitalists”)
* Earn fees paid by limited partners
* General annual management fee (usually around 2% of the fund’s committed capital)
* Carried interest: 20%-30% of any positive return they make

Question 7

The idea that when a seller has private information about the value of goods, buyers will discount the price they are willing to pay due to adverse selection is known as the

Answer 7

lemons principle

Question 8

What is Preferred stock

Answer 8

Its issued by young companies has seniority in any liquidation but typically does not pay regular cash dividends and often contains a right to convert to common stock.
* Different from preferred stock issued by mature companies, which usually has a preferential dividend and
seniority in any liquidation and sometimes special voting rights.

Question 9

What is Convertible Preferred Stock

Answer 9

Preferred stock that gives the owner an option to convert it into common stock on some future date

Question 10

What are ways VC’s gain bargaining power in negotiating?

Answer 10

Terms depending on bargaining power (e.g. better terms for start-up in up rounds):
* Liquidation Preference: minimum amount paid to preferred stock before common stock in liquidation
* Seniority: over investors in earlier rounds
* Participation Rights: liquidation preference and rights to payments to common shares
* Anti-Dilution Protection: right to purchase common stocks at better price in down rounds
* Board Membership: investors appoint board members to secure control rights and prevent moral hazard

Question 11

What is a Special Purpose Acquisition Companies (SPAC)

Answer 11

SPACs first raise financing in an IPO, and then find a private firm to merge with
Thereby, SPACs take private firms public

Question 12

What is a syndicate

Answer 12

A group of underwriters who jointly underwrite and distribute a security issuance

Question 13

What is a Seasoned Equity Offering (SEO)?

Answer 13

SEO: a public company offers new shares for sale to raise additional equity
* Main difference to IPO: market price for the stock already exists, so the price-setting process is not
necessary

Question 14

What are the two types of SEO offerings

Answer 14

• Cash Offer: firm offers the new shares to investors at large
• Rights Offer: firm offers the new shares only to existing shareholders
  protects existing shareholders from underpricing

Question 15

What is the IPO/SEO underpricing Puzzle

Answer 15

Generally, underwriters set the issue price so that the average first-day return is positive
* About 75% of first-day returns are positive
* The underwriters benefit from the underpricing because it allows them to reduce risk
* The pre-IPO shareholders bear the cost of underpricing
* In effect, these owners are selling stock in their firm for less than they could get in the aftermarket
LINK TO WINNERS CURSE

Question 16

What is the puzzle around high IPO/SEO underwriter fees

Answer 16

A typical spread is 7% of the issue price!
* This is a large fee, especially considering the additional underpricing cost
* One possible explanation is that by charging
lower fees, an underwriter may risk signaling that it is not the same quality as its higherpriced competitors
* Although not as costly as IPOs, SEOs are still expensive: underwriting fees amount to 5% of the proceeds of the issue.

Question 17

What is the IPO/SEO Cyclicality Puzzle

Answer 17

The number of issues is highly cyclical: in good times, the market is flooded with new issues; in bad times, the number of issues dries up
* What is surprising is the magnitude of the swings
* Unlikely explained by swings in available growth opportunities alone
* Cyclicality in the supply of capital likely plays a role too

Question 18

What SEO Price reactions Puzzle

Answer 18

On average, the market greets the news of an S E O with a price decline
* The stock price tends to rise prior to the announcement of an equity issue
* Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements
* All consistent with adverse selection (see formal model)

Question 19

Pecking order: under adverse selection about the quality of new investments, firms prefer to first use the least information-sensitive sources of financing

What is the order that they use?

Answer 19

1. Internal resources (cash, retained earnings)
2. Senior debt (with little default risk)
3. Junior debt, convertibles
4. External equity

Question 20

What are the Implications for Equity Issuance (SEO Price Reaction Puzzle)

Answer 20

The stock price declines on the announcement of an equity issue: market suspect the issuing firm may be a lemon

Question 21

under assymetric information, what kind of equilibrium obtains and who receives financing

Answer 21

pooling equilibrium in which both good and bad firms receive financing

Question 22

What is the Incentive-compatibility (IC) formula

Answer 22

• Goal: find cutoff level 𝑒̅, such that owner-manager exerts effort as long as 𝑒 ≤ 𝑒̅

Question 23

What is the participation constraint (PC) formula

Answer 23