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• Value additivity:
• Firm value:
• Identical firm:
2 Firms: 1, 2
• At t = 0,
– Risk-free rate: r.
– Market value of firm i’s debt: Di.
– Market value of firm i’s equity: Ei.
– Total market value of firm i: Vi = Di + Ei.
• Hence, at t:
αV2 = · D1 + · E1.
V1 V1
• At t, the investor would receive:
αV2 αV2
Main insight:
Main idea:
• Notation:
– Riskfree rate: r.
– Corporate tax rate: τ .
|
(1 − τ ) (X
{z
− rD) }
+ | rD
{z }
to equityholders to debtholders
• Rewrite as:
|
(1 −{zτ ) X } + | τ rD
{z }
• By value additivity:
V (D) = V (0) + V (Tax Shield Perpetuity).
• As leverage increases:
• Remarks/Implications:
(1−τ )(1−τE )
• If 1−τD > 1:
Miller (1977).
1
– For r > r0 (1−τ ) , firms issue no debt, only equity.
1
– For r < r0 (1−τ ) , firms issue only debt, no equity.
1
– For r = r0 (1−τ ) , firms are indifferent between issu-
ing debt and equity (⇒ Perfectly elastic supply).
Equilibrium:
– Tax rates.
– Funds available to investors in each tax bracket.
• Clientele effect:
• Implication:
• Moral hazard.
• Moral hazard and credit rationing.
• Jensen and Meckling (1976).
– Effort problem.
– Risk-shifting problem.
INCENTIVE ISSUES
Main idea:
• At t = 1: Moral hazard.
• At t = 2: Cash flow.
L H
– X ∈ X ,X with ∆X ≡ X H − X L > 0,
H
– and Pr X = X ≡ θ + e · ∆θ .
Assumption (*): e = 1 is efficient, i.e.,
∆θ ∆X > c.
Assumption: The project’s value is positive if e = 1,
i.e.,
V1 ≡ X L + (θ + ∆θ ) ∆X − I − c > 0.
• “Effort” is a metaphor
• The incentives of the party taking operating decisions
depends on his claims.
• Therefore, the pie size is affected by how it is split.
⇒ Violates one MM assumption.
Financial Contracts
• Limited liability:
RL ≤ X L and RH ≤ X H
Examples:
• Fraction β of equity:
RL = βX L and RH = βX H .
• Etc.
Remark:
What if W < I?
H H
What if Rmin > Rmax ?
• The project’s value for e = 0 is:
V0 ≡ X L + θ∆X − I.
• Credit rationing:
– Suppose V0 < 0.
– The entrepreneur cannot raise (I − W ), irrespec-
tive of RH .
• Deviation from value maximization:
– Suppose V0 > 0.
– The entrepreneur can raise (I − W ) but fails to
use these funds optimally.
Commitment Problem
• Conflicts of interests:
• Specific costs:
I − XL
L
• He can issue debt with face value K = X + ,
θ + ∆θ
i.e.,
RL = min{X L, K} = X L RH = min{X H , K} = K.
RL ≤ X L RH ≤ X H
I ≤ RL + (θ + ∆θ ) ∆R
Equity:
No:
Main ideas:
• Misallocation of funds.
• Credit rationing: Some valuable projects
cannot be financed.
• Costs incurred to prevent the above such
as:
– Monitoring.
– Signalling.
– Etc.
Model
• At t = 1:
– Need I > 0.
– Entrepreneur’s resources available W < I.
• At t = 2:
L H
– Cash flow X ∈ X , X .
– Pr X = X H ≡ θ ∈ {θB , θG}.
– ∆θ ≡ θG − θB > 0.
Notation:
• For instance,
I −W
RL = 0 and RH = .
θ
Information Asymmetry
• In other words:
H
• Incentive Compatibility Constraints: RB and
H
RG are optimal for the bad and good type respectively
given the investors’ beliefs.
| W{z } + |
V {z(θ) }
Available Wealth Firms Actual Value
H H H
+ |
θ̂(R )
{z
· R }
− θR
{z
| }
|
W + V{z (θ) }
− θ − θ̂(R ) RH
H
| {z }
Ents true worth IA discount
Note: The discount can be negative.
Separating Equilibria with Both Types
Investing
H H
• If RG 6= RB , Bayes Rule pins down the investors’
beliefs:
H H
θ̂(RG ) = θG and θ̂(RB ) = θB .
H
• The bad entrepreneur’s payoff from playing RB is:
H
|
W + V{z(θB ) }
− |
(θB − {zθB ) RB }
true worth =0
H
• By deviating to RG , he would get:
H
|
W + V{z(θB ) }
− (θ
|
B − θ G
{z
) R G }
true worth <0
• ⇒ No such equilibrium.
Separating Equilibria with Only Bad Types
Investing?
• ⇒ No such equilibrium.
Separating Equilibria with Only Good Types
Investing
– for smaller (I − W ),
– for more negative V (θB ).
• Feasibility constraint:
R0H ≤ X H . (1)
min RH
s.t.
H
θ̂R ≥ I (F) Feasibility
RH ≤ X H (LL) Limited Liability
(1) Under-investment.
Internal funds:
Information-insensitive assets:
First best:
Assumption (**):
θG(1 − θ̂) u0 (0)
> .
θ̂ (1 − θG) u0 (X H )
• That is,
∂UθG (α, θ̂X H )
> 0 at α = 1.
∂α
• This implies
∂UθG (α, θ̂X H )
> 0 for all α.
∂α
• ⇒ Good entrepreneurs prefer to retain their claims
and be exposed to risk rather than selling underpriced
claims.
• ⇒ Investors’ rational expectations should reflect that
good types are not selling claims on all cash flows.
• ⇒ This affects the price.
• ⇒ We need to analyze equilibria.
Example:
No Perfect Bayesian Equilibrium with αG = 0
• Suppose that αB 6= 0:
• ⇒ No pooling equilibrium.
A Separating Equilibrium
αG = 1.
• αG = 1.
• αB = 0.
• ∀α 6= 1, ν (α) = 0.
• ν (1) = 1.
• Indeed, under Assumption (**)
H
∂UθG α, θB X
> 0 ∀α.
∂α
Ross (1977).
Main idea:
λV0 + (1 − λ) V1 − (K − X)+ ,
where
• λ ∈ (0, 1).
• Vt : Firm’s market value at t.
• (K − X)+: Cost incurred by the manager in financial
distress.
• Note: No uncertainty after t = 1. ⇒ V1 = X.
Debt as a Signal
Pooling Equilibria
1 − θG
V (θG) − λ∆V .
1 − θB
• If the good type is better off in the “best” separating
than in any pooling PBE, Cho-Kreps selects that PBE,
i.e.,
1 − θG
λ V (θG) − V̂ > λ ∆V .
1 − θB
Comments
• KG∗ is increasing in λ.
• λ may be interpreted as the intensity of the takeover
threat: