1.

Explain the impact of information asymmetry on market efficiency

Information asymmetry is a situation in which one party in a transaction has
more or superior information compared to another. This often happens in
transactions where the seller knows more than the buyer, although the
reverse can happen as well. Potentially, this could be a harmful situation
because one party can take advantage of the other party's ignorance.
Information asymmetry lead to market inefficiencies by introducing adverse
selections into transactions between buyers and sellers. The economic costs
of information asymmetries can be understood along two different markets(1) Primary markets; and
(2) Secondary markets.
On the former markets and under conditions of adverse selection, any firm
confronted with financing problems will have no other choice than to issue
new securities at a relatively large discount as a result of high degree of
information asymmetry in the cost of equity capital.
The side-effects of Informational efficiency on secondary markets are quite
similar to and perhaps more important than those on primary markets. Events
in the secondary markets frequently provide the basis for the terms and
conditions that will prevail in the primary market. Thus, firms would have hard
time attracting buyers in the primary market without the desired flexibility in
trading provided through the secondary market.
In traditional economic theory, buyers know everything they need to know
about goods and services offered for sale. But everybody knows that this is
not true in reality. The problem is that sellers with high quality products are at
the risk of leaving the markets because the price reflects the average product
and the buyers cannot distinguish the high quality from the low quality
products. There is a clear incentive for sellers of high quality product to pass
on this information to their buyers. Full disclosure may help but legislating for
it has its own economic inefficiencies.
One way to resolve problems due to asymmetric information is to provide
buyers with guarantees that the good they buy is of high quality. It will cost
the seller but it reveals the information and the buyers may pay for it.
Numerous applications extend this theory and confirm the importance of
signalling on different markets. This covers phenomena such as costly

advertising or far-reaching guarantees as signals of productivity, aggressive

price cuts as signals of market strength, delaying tactics as a signal of
bargaining power, financing by debt rather than by issuing new shares as a
signal of profitability and recession-generating monetary policy as a signal of
uncompromising commitment to reduce stubbornly high inflation. Another
effective way of resolving the negative impact of asymmetric information is to
provide

clients

(the

informed

party)

effective

incentives

to

"reveal"

information on their risk situation through so-called screening.

2. What is lemon and adverse selection?
The lemons problem
Three economists were particularly influential in developing and writing about
the theory of asymmetric information: George Akerlof, Michael Spence and
Joseph Stiglitz. All three shared the Nobel Prize in economics in 2001 for their
earlier contributions. Akerlof first argued about information asymmetry in a
1970 paper entitled "The Market for 'Lemons': Quality Uncertainty and the
Market Mechanism." Therein, Akerlof stated that car buyers see different
information than sellers, giving sellers an incentive to sell goods of less than
average market quality. Akerlof uses the colloquial term "lemons" to refer to
bad cars. He espouses a belief that buyers cannot effectively tell lemons
apart from good cars. Thus, sellers of good cars cannot get better than
average market prices.
Hence, the issue of information asymmetry between the buyer and seller of
an investment or product is called Lemons problem. Information asymmetry
arises when the parties to a transaction do not have the same degree of
information necessary to make an informed decision. For example, in the
market for used cars, the buyer generally cannot ascertain the value of a
vehicle accurately and may therefore only be willing to pay an average
price for it, somewhere between a bargain price and a premium price.
However, this tilts the scales in favour of a lemon seller, since even an
average price for this lemon would be higher than the price it would
command if the buyer knew beforehand that it was indeed a lemon. This
phenomenon also puts the seller of a good used car at a disadvantage, since
the best price such a seller can expect is an average price, and not the
premium price the car should command.

Adverse Selection
Adverse selection, anti-selection, or negative selection refers to a
market process in which undesired results occur when buyers and sellers
have asymmetric information (access to different information); the "bad"
customers are more likely to apply for the service. For example, a bank that
sets one price for all of its checking account (current account) customers runs
the risk of being adversely selected against by its low-balance, high-activity
(and hence least profitable) customers.
Very little positive correlation between insurance and risk occurrence has
been observed in real markets, for instance. One possible explanation for this
is that individuals do not actually have more information about their risk type,
while insurance companies have actuarial life tables and significantly more
experience.
3. Briefly explain the means of mitigating agency costs of managerial
discretion.
Agency costs arise because of core problems such as conflicts of interest
between shareholders and management. Shareholders wish for management
to run the company in a way that increases shareholder value. But
management may wish to grow the company in ways that maximize their
personal power and wealth that may not be in the best interests of
shareholders.
The means of mitigating agency costs of managerial discretion are as follows:
a) Hiring managers as monitors of teamwork may mitigate the moral
hazard problem and elicit mutually cooperative best efforts from all
members of a team.
b) Governance mechanisms (including internal or external monitoring)
can be used to ascertain the extent to which the managers actions are
consistent with the value creation objective of shareholders.
c) Linking compensation to firm performance provides an important
means for attenuating the agency problem.
d) The misalignment of interests between managers and shareholders is
diminished to the extent that managers are themselves owners of the
firm.

4. Explain the underinvestment problem.

A problem where a company management refuses to invest in low-risk assets,
in order to maximize their wealth at the cost of the debt-holders. Low-risk
projects provide more security for the firm's shareholders, since a steady
stream of cash can be generated to pay off the lenders. The safe cash flow
does not generate an excess return for the shareholders. As a result, the
project is rejected, despite increasing the overall value of the company.
Shareholders under-invest capital by refusing to participate in low-risk
projects. This is similar to the asset substitution problem, where shareholders
exchange low-risk assets for high-risk ones. Both instances will increase
shareholder value at the expense of the debt holders. Since high-risk projects
may most likely have large profits, the shareholders benefit from increased
income, as the debt holders require only a fixed portion of cash flow. The
problem occurs because the debt holders are not compensated for the
additional risk.
5. Discuss the consequences of violation of the assumption of ideal
capital market.The assumption under which a market or an economy is entirely efficient is
known as perfect market theory. Perfect market assumptions include equal
access to information by all market participants, completely rational economic
factors, and no transaction costs (such as taxes). Perfect market assumptions is
rarely true in the real world.
The critical assumptions of the Merton Miller of perfect capital markets are:
a) Capital markets are frictionless - Market participants face no transaction
costs or taxes. Investors face no brokerage commissions or fees on trades,
and short selling is restricted. Firms face no transaction costs in issuing or
retiring securities, and there are no costs associated with bankruptcy.
b) It is a tax-free world.
c) All market participants share homogenous expectations and relevant
information is costlessly available to all market participants, and all
participants rationally process such information to determine the value of
any security. Thus, all participants share common expectations about the
prospects of investments
d) Infinitely divisible securities.

e) The firms investment program is fixed and known The firms investment
program, and therefore its assets, operations, and strategies are fixed and
known to all investors.
f) The firms financing is fixed once chosen, the firms capital structure is
fixed.
The consequences of violation of the assumption of ideal capital market
are:
1. Transaction cost and personal taxes may affect investors ability to
undertake arbitrage, which is very important for MM theory propositions,
the CAPM model, the Binomial Pricing Model, and the BSOPM Model.
2. Variation in personal tax rates and transaction costs across both investors
and securities may differentially affect the values of corporate securities
&e.g. debt vs. equity, and ultimately a firms preference for issuing one
type of security vs. another. If a firms earnings are taxed, and interest
payments are deductible while dividends are not, a firms preferences for
debt vs. equity financing may be determined in part by the effect of taxes
on the market value of the firm.
3. If a firm faces transaction costs in issuing securities, such frictions may
prevent its ability to undertake profitable investment opportunities, thus
affecting choice of debt vs. equity financing.
4. Costs of financial distress and bankruptcy, which are basically transaction
costs associated with the presence of debt in a firms capital structure,
may create problem in issuance of debt.
5. Firm may issue substantial securities and can opt for repurchase of shares
outstanding both the type of transactions may affect the market value of
securities on the other hand atomistic competition also brings about
principle vs agent conflict. The investors themselves are so many that
they cannot personally monitor the firm. Therefore they appoint a
manager, who in turn pursues his own interests.

Thus atomistic

assumption needs to be violated to avoid adverse effects of a real world

situation.
Discuss the traditional trade off theory and various empirical studies to
prove the theory.
The Trade-off

theory

of

capital

structure refers

to

the

idea

that

a company chooses how much debt finance and how much equity finance to
use by balancing the costs and benefits. Trade-off theory of capital structure
basically entails offsetting the costs of debt against the benefits of debt.

The Trade-off theory of capital structure discusses the various corporate

finance choices that a company experiences. The theory describes that the
companies or firms are generally financed by both equity and debt.
The marginal benefit of further increase in debt declines as debt increases,
while the Break Even Level increases, so that a firm that is optimizing its
overall value will focus on this trade-off when choosing how much debt and
equity to use for financing.
Modigliani and Miller in 1963 introduced the tax benefit of debt. Later work
led to an optimal capital structure which is given by the Trade Off theory.
According to Modigliani and Miller, the attractiveness of debt decreases with
the tax on the interest income. A firm experiences financial distress when the
firm is unable to cope with the debt obligations. If the firm continues to fail in
making payments to the debt holders, the firm can even be insolvent.
Trade-off theory of capital structure can also include the agency costs
from agency theory as a cost of debt to explain why companies dont have
100% debt as expected from Modigliani and Miller. 95% of empirical papers in
this area of study look at the conflict between managers and shareholders.
The others look at conflicts between debt holders and shareholders. Both are
equally important to explain how the agency theory is related to the Trade-off
theory of capital structure.
The direct cost of financial distress refers to the cost of insolvency of a
company. Once the proceedings of insolvency starts, the assets of the
firm may be needed to be sold at distress price, which is generally much
lower than the current values of the assets. A huge amount of administrative
and legal costs are also associated with the insolvency. Even if the company
is not insolvent, the financial distress of the company may include a number
of indirect costs like cost of employees, cost of customers, cost of suppliers,
cost of investors, cost of managers and cost of shareholders.
The firms may often experience a clash of interest among the management of
the firm, debt holders and shareholders. These disputes generally give birth
to agency problems that in turn give rise to the agency costs. The agency
costs may affect the capital structure of a firm. There may be two types of
conflicts shareholders-managers conflict and shareholders-debt-holders
conflict. The introduction of a dynamic Trade-off theory of capital structure

makes the predictions of this theory a lot more accurate and reflective of that
in practice.