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Equity Issues
First time a firm seeks public equity is called an initial public offering (IPO)
Primary issue: new equity is issued Secondary issue: existing private equity is sold to outside investors (most privatisations take this form) Legal and underwriting services provided by investment banks
Debt Issues
Bank loans not publicly traded Corporate Bonds traded actively in the secondary market Debt capital and equity capital account for most of the firms financial capital
Definition of Debt
Fixed claim
Specifies what needs to be repaid to the investor and when Default risk risk that the repayment plan is not fulfilled Conversion options covenants that allow debt to be reclassified as equity
Definition of Equity
Residual claim
Does not specify a repayment plan Repayment is defined as the residual: whatever is not claimed by other claim holders should go to the equity holders Voting rights: Equity holders normally have a right to vote on important corporate decisions
Mergers, takeovers Large investments Board representation
Readings
Grinblatt/Titman: Financial Markets and Corporate Strategy
Ch 1: overview of the process of raising capital for investment Ch 2: overview of the process of raising debt capital Ch 3: overview of the process of raising equity capital
Problems
1. Why do firms use underwriters when they issue new equity? 2. In what ways do you think it matters that debt holders have a fixed claim when equity holders have not? 3. In what ways do you think it matters that equity holders have voting rights when debt holders have not?
Review problems
1. 2. 3. 4. 5. Invest 95 and sell for 102 what is the return? Invest 95 and sell for 102. Each transaction is charged a 1% trading commission what is the return? Invest 95 and sell for 102. You receive additional interest payments/dividends of 2 during the holding period. What is the return? Invest 95 and sell for 110 three years later what is the annual return on your investment? Invest 95 now and another 98 next year. In the following year you sell your investment for a total of 202. What is the annual return on your investment?
Tool box
Optimal investment
Fair price of an asset means that the value equals the purchasing price Even if prices are fair there are still ways of investing your money that is better than others
Risk Aversion
Investors demand compensation for including risk in their portfolio
Portfolio weights
A portfolio of financial assets can be represented in a number of ways
The number of shares held in the various stocks (e.g. 1000 shares in BT, 250 shares in Marks&Spencer etc.) The dollar-value held in the various stocks (e.g. 2,500 in Lloyds Bank, 10,000 in Jarvis etc.) As portfolio weights: the dollar-weight of the various stocks (e.g. if total portfolio is 100,000, then the portfolio weight of Lloyds is 0.025 and the portfolio weight of Jarvis is 0.1 etc.)
Formulas
E ( rP ) ! wi E (ri )
i !1 N
E (rP ) ! wE (r1 ) (1 w) E (r2 ) Var (rP ) ! w2Var (r1 ) (1 w) 2 Var (r2 ) 2 w(1 w)Cov(r1 , r2 )
Portfolio Frontier
Mean-Std Dev for Portfolios of the Risk Free Asset and a Risky Asset
Algebraic proof
r ! rP mri mrF ! rP m(ri rF ) E ( r ) ! E (rP ) m( E (ri ) rF ) Var ( r ) ! Var ( rP ) m Var (ri ) 2mCov(rP , ri )
2
Readings
Chapter 4 in Grinblatt/Titman
Problems
1. Variance: Prove that E(x-E(x))2=Ex2(E(x))2 2. Covariance: Prove that E(x-E(x))(yE(y))=Exy-E(x)E(y) 3. Take a time series of returns 0.05, -0.03, 0.10, 0.04, -0.10, 0.20. Estimate the expected return and the variance of return.
Two-fund Separation
Optimal diversification Market vs idiosyncratic risk
max
w
E ( rT ) rF Var (rT )
E (rT ) ! wE (rA ) (1 w) E (rB ) Var (rT ) ! w 2Var (rA ) 2w(1 w)Cov( rA , rB ) (1 w) 2Var (rB ) w( E (rA ) E (rB )) ( E ( rB ) rF ) max w Var (rT )
Example
.002 .001 0 Var/Cov ! .001 .002 .001 0 .001 .002
Example cont..
.002w1 .001w2 0 w3 ! .15 .06 .001w1 .002w2 .001w3 ! .17 .06 0w1 .001w2 .002 w3 ! .17 .06 w1 ! 40 w2 ! 10 w3 ! 50 w1 ! .4, w2 ! .1, w3 ! .5
Properties of betas
Beta is linear: the beta of a portfolio of securities equals the portfolio-weighted average of the betas of the individual securities An implication is that the beta of the assets of the company equals the valueweighted beta of the liabilities of the company
Tracking portfolios
A portfolio tracks another perfectly if the difference in the returns of the portfolios is a constant (possibly zero) Imperfect tracking: A portfolio consisting of a weight (1-b) in the risk free asset and a weight b in the tangency portfolio tracks a stock with beta =b, because the two should have the same expected return
Tracking Errors
The two investments should have the same expected return, which implies that the tracking error has zero expectation and zero value Of course, investors do not like risk so they choose to hold the tracking portfolio instead of the stock Because such diversification is free of cost, the tracking error is also free of cost (i.e. it has zero value)
Beta estimation
A raw beta estimate can be obtained from historical covariance and variance estimates (or by a regression) Average beta is one (this is the beta of the market index) If the raw estimate exceeds (is below) one, we know there is a possibility that the raw beta is an overestimate (underestimate) Raw beta estimates should be adjusted i.e. they should be pulled down if they are above one or be bumped up if they are below one. There are ways of optimally adjust beta estimates
Beta Adjustment
Bloomberg adjustment
Adjusted beta = .66 times Unadjusted beta + .34 times One
Rosenberg adjustment
Adjustment also incorporates fundamental variables (industry variables, company characteristics such as size, etc..)
Also betas are adjusted sometimes to take into account infrequent trading problems
Readings
Grinblatt/Titman ch 5
Problems
What is the tracking portfolio for a real asset? How would you estimate the beta of the assets of a firm that has traded debt and equity? How would you estimate the beta of a company that has never traded?
Risk Decomposition
The Market Model
One-factor (the return on the market portfolio) Related to the CAPM model The regression estimates of the market model generates raw beta-estimates for the CAPM
Risk Decomposition
Systematic (market) risk: asset risk that is explained by market movements Unsystematic (diversifiable, idiosyncratic) risk: asset risk that cannot be explained by market movements
Risk Decomposition
var(rit ) ! total risk var(F i rMt ) ! F var(rMt ) ! market risk
2 i
bj b j bi
bj ~ rj ! risk free ! rF ri 1 b b b j bi j i
Multi-factor models
K - factor model E (ri ) ! rF bi1P1 bi 2 P2 . biK PK rit ! ai bi1 f1t bi 2 f 2t . biK f Kt I it
~ ~ ~ ~ ~
Factor betas
The betas determine the assets sensitivity to the factors A high loading on factor number 2 means that the asset is particularly sensitive to risks associated with factor 2 Factor models extends into portfolio analysis since the factor betas of portfolio is just the value-weighted average factor beta for the individual assets in the portfolio
Variance estimation
var(r i ) ! bi2 var( f ) var(I i )
~ ~ ~
Tracking Portfolio
Objective: to design a portfolio that has certain factor betas (or factor loadings) Why? The use of tracking portfolios are many
Risk management: if the company is subject to risks beyond its control, e.g. currency risk, it may create a tracking portfolio that offsets the risk Capital allocation: the company may wish to allocate capital to investments that yield a greater return than their tracking portfolio and to reduce its exposure to investments that yield a smaller return than their tracking portfolio
Example
Two - factor tracking portfolio, target betas 1 and 2 for factor 1 and 2 respectively Three assets with factor beta 1, 3, 1.5 for factor 1 and - 4, 2, 0 for factor 2 Calibration : x1 x2 x3 ! 1 x1 3x2 1.5 x3 ! 1 4 x1 2 x2 ! 2 Output : x1 ! 0.1, x2 ! 0.3, x3 ! 0.8
Readings
Chapter 6 in Grinblatt/Titman
Problem
There are three relevant factors driving asset returns
The factor structure of the debt of the company is (0.01, 0,0) The factor structure of the equity of the company is (2,5,1) The company consists of 1/3 debt and 2/3 equity
Fisher Separation
With different tastes, why should investors agree on investment policy?
Long-term vs short term Risky vs Risk free
Fisher separation
Agreement is optimal regardless of taste Net present value rule: Invest in all projects that cost less than the value of the projects tracking portfolio NPV = PV(future investment) Investment cost
Ingredients
Cash flows of our investment Investment cost Discount rates (if risk free projects use a risk free discount rate)
Capital Constraints
There are situations in which you may have more projects with positive NPV available than you have funds for investment i.e. you have a budget constraint Then the choice criterion is to invest in the projects that offer the greatest profitability index
Profitability Index
Present Value cash flow PV Investment cost I 0 Net present value NPV ! PV I 0 PV Profitability Index PI ! I0
Example
Project A : PV A ! 10m, I A ! 8m Project B : PVB ! 100m, I B ! 90m Project C : PVC ! 1000m, I C ! 950m What is the optimal investment policy if the projects are independent? What is the optimal investment policy if the projects are mutually exclusive? Total investment budget B ! 100m. What is the optimal investment policy subject to staying within budget?
Example cont.
Profitability indexes : 10 ! 1.25 8 100 ! 1.1111 PI B ! 90 1000 ! 1.0526 PI C ! 950 Invest in A first, then B and C. PI A ! Optimal mix : All of A (using 8 of 100 budget) plus all of B (using additional 90 of budget, leaving 2 to invest in C) plus 2 ! 0.2105% of C 950 2 Total NPV : (10 8) (100 90) (1000 950) ! 12.11 950
EVA: Definition
Three components
Cash flow Change in asset base Economic return on assets
EVA(t) = Ct + (It It-1) rIt-1 EVA(t) = Ct + It (1+r)It-1 Discounted sum of EVA(t) = Net Present Value
EVA, cont.
Investment of 100 The first year cash flow is 50 The second year cash flow is 150 Discount rate is 10% Assets are depreciated by 50% in the first year and by 100% in the second year.
EVA, cont.
EVA(0) = -100(cash flow)+(100-0)(change in assets)0(0.1)(economic cost of initial assets) = 0 EVA(1)=50(cash flow)+(50-100)(change in assets)100(0.1)(economic cost of initial assets) = -10 EVA(2)=150(cash flow)+(0-50)(change in assets50(0.1)(economic cost of initial assets)= 95 Discounted EVA = EVA(0)+EVA(1)/1.1+EVA(2)/1.12 = 69.42 = NPV
IRR
C1 C2 CT . NPV ! I 0 2 T 1 r (1 r ) (1 r ) C1 C2 CT . 0 ! I0 2 1 IRR (1 IRR) (1 IRR)T
Example
Investment cost = 100 First years cash flow = 150 Discount rate 10% NPV = -100+150/1.1=36.36 IRR: 0=-100+150/(1+IRR) yields 50% Since 50% > 10% (IRR > discount rate) it is optimal to adopt the project
Important points
Fisher separation NPV definition NPV with mutually exclusive projects (either-or) NPV with budget constraints EVA and NPV IRR IRR pitfalls
Readings
Grinblatt/Titman chapter 10
3.
Example
Value assets 100, value debt 40, and value equity 60. Estimated equity beta 1.5 Estimated debt beta 0 40 1.5 ! F A ( F A 0) 60 1.5 implies F A ! ! 0. 9 40 1 60
Cont
0.72 0.77 0.85 Average beta ! project beta ! 0.78 ! 3 Risk free rate 4% and market risk premium 8.4%. Cost of capital (discount rate) for the project is 0.1055 ! 0.04 0.78(0.084)
Applying APT
The APT model estimates the cost of capital by a factor model, so present values are given by E (Ct ) PV ( E (Ct )) ! t (1 rF F1P1 . F K PK )
Example
Investment cost 100,000 Annual running cost 5,000 for 5 years Expected revenue stream 50,000 for 5 years Beta-risk of revenue stream 1.2 Risk free return 5% Expected market return 12%
Example cont
The discount rate for running costs : 5% (as the costs can be assumed risk free?) The discount rate for the revenue stream : 5% 1.2(12% 5%) ! 13.4% PV ! 5(1.05) 1 5(1.05) 2 5(1.05) 3 5(1.05) 4 5(1.05) 5 50(1.134) 1 50(1.134) 2 50(1.134) 3 50(1.134) 4 50(1.134) 5 ! 21.65 174.16 ! 152.51 NPV ! 100 152.51 ! 52.51 " 0 Therefore, adopt project.
Readings
Grinblatt & Titman chapter 11 I have not emphasized the certainty equivalent method
Modigliani-Miller
The operating cash flow is divided into two components
Cash flow to debt holders Cash flow to equity holders
Fundamental question: Does it matter how the split is made? If it does we can create value also through financing choices (not only through investment choices)
MM cont
Modigliani-Miller proved that capital structure choices are irrelevant the split does not matter This proof rests on the absence of transaction costs of any kind: taxes, trading costs, and bankruptcy costs The proof of the MM theorem uses a no arbitrage argument financial markets do not admit free lunches, or trading strategies giving you a positive cash flow with no prior investment
MM cont
Consider two versions of the same firm one version is U for unlevered (with no debt) and the other version L for levered (with debt) The firms have otherwise the same operating cash flow X The unlevered firm has value VU and the levered firm value VL
MM cont
The fundamental question is whether VU and VL differ The cash flows of firm Us equity holders is simply X The cash flow of firm Ls debt holders is (1+r)D to the firms debt holders and X-(1+r)D to the firms equity holders, in total a cash flow of X also The value of L is the combined value of the debt and the equity
MM cont
Suppose VL is smaller than VU Then an investor can buy a 10% holding of Ls debt and a 10% holding of Ls equity, which entitles the investor to a 10% share in the total cash flow X. He would then go to the market and sell 10% of the cash flow X, which is valued at 10% of the value of U. This leaves him with zero future liability. His trading gains are 10% of the difference between VU and VL, which we have assumed is positive This cannot be possible in an arbitrage free market, so we can conclude that VL must be equal to or greater than VU
MM cont
Now suppose VU is smaller than VL An investor buys 10% of the cash flow X and sells 10% of a claim that promises the cash flow (1+r)D. The net cash flow is 10% of a claim that pays X-(1+r)D at maturity, which is priced at 10% of the equity in L The net future liability is zero, and the trading gains equal 10% of the difference between VL and VU, which we have assumed positive Again, this is not consistent with arbitrage free markets In conclusion, it must be the case that VU = VL and that capital structure is irrelevant
Bankruptcy costs
The Modigliani-Miller theorem also assumes that there are no deadweight costs of bankruptcy The debt holders may not get all their money back if the firm defaults, but this is not in itself enough to jeopardise the MM-theorem There must also be deadweight costs or liquidation costs (i.e. the value of the assets in default is less than the value of the assets as a going concern)
Algebra
After tax cash flow from investor perspective C ! ( X kD)(1 tC )(1 t E ) kD(1 t D ) (1 tC )(1 t E ) ! X (1 tC )(1 t E ) kD(1 t D )1 1 tD Discounted after tax cash flow X (1 tC )(1 t E ) kD(1 t D ) (1 tC )(1 t E ) 1 DC ! 1 r 1 r 1 tD ! Value unlevered firm discounted tax benefits
Equilibrium
If there is a positive discounted tax benefit firms choose to borrow more, and investors with higher personal tax rate on debt income is encouraged to enter the market. This implies a reduction of tax benefits of borrowing. Reverse effect is there is a negative discounted tax benefit of borrowing In equilibrium, we expect the tax benefit from borrowing to be equal to zero This is the so-called Millers equilibrium described in Appendix 14A in the textbook
Preferred stock
Preferred stock: dividends on preferred stock are not tax deductible at the corporate level as are interest payments on debt This implies that corporate junior debt may be tax efficient relative to preferred stock However, the US tax code allows a 70% tax exclusion for preferred dividends paid to corporate holders, so the yield on preferred stock is often lower (before tax) than on junior debt even though the debt has seniority over the preferred stock
Investor conflicts?
Tax exempt equity holders prefer in general to reduce the borrowing of the firm so as to transfer income from debt repayments to dividend payments High-tax bracket investor prefer the opposite Often tax-exempt municipal bonds (or similar investments) offer yields that are greater than the after tax yield on corporate bonds for high-tax bracket investors Thus, the firm can give these investors an advantage by increasing the firms borrowing, as this frees capital that the investors can use to invest in tax-exempt municipal bonds
Inflation
We expect to see a one-to-one relationship between inflation and nominal interest rates - if inflation increases by one percentage point then so do nominal interest rates Higher inflation, therefore, leads to higher nominal borrowing costs that yield in turn greater tax deductions Therefore, the tax effect has greater bite in periods of high inflation
Empirical evidence
Do firms with greater taxable earnings borrow more?
No, but this may be because firms in general rarely issue equity Firms that perform poorly, therefore, tend to accumulate debt to meet their investments
Tax code changes that affect the relative tax benefit of borrowing should have an impact on corporate financing
Yes, US tax reform of 1986 which reduced the tax benefits of other things than debt (such as depreciation rules and investment tax credits) gave rise to an increase in borrowing among firms most affected The firms less affected did not increase their borrowing to the same extent
Readings
Grinblatt/Titman chapter 14, including the appendix 14.10 Are There Tax Advantages to Leasing not so relevant
Exercises
1. A firm has assets valued at 100, and debt valued at 50. It plans to restructure its liability side by increasing its borrowing to 70 and paying a dividend of 20 to its shareholders. The debt has zero beta before and 0.001 beta after the recapitalization. The beta of the equity is 2 before the recapitalization.
a) b) c) d) What are the values of the equity before and after the recapitalization? What is the beta of the assets of the firm? What is the beta of the equity after recapitalization? The recapitalization has increased the beta of the debt (and therefore the cost of debt capital). Has it also increased the beta of the equity? Does this mean that the total cost of financing has increased? Explain.
Dividend yields
Dividend yield is the ratio of dividends per share over price per share Typical pattern is that high-tech growth firms have low dividend yield and dividend payout ratios (Microsoft paid its very first dividend this year) Stable, old economy companies such as mining, oil and manufacturing pay about half their earnings as dividends
Modigliani-Miller Irrelevance
Consider two identical equity financed firms, the only difference is dividend policy Firm 1 pays 10m as dividends Firm 2 repurchases stock worth 10m After the end of the year, the firms are worth X In the beginning each firm has 1m shares outstanding
MM cont
Each share eventually sells for X divided by the number of shares Firm 2 buys back 10m worth of stock If share price is p, and firm 2 buys back n shares, we know that pn=10m We also know that p=X/(1m-n) Suppose X = 150m Solving both equations gives us n = (10m1m)/(X+10m), so we get n = 62,500, and p = 150m/(1m-62,500) = 160 Firm 1: stock price is p = 150m/1m = 150, but each stock gives a dividend worth 10m/1m = 10, so the total value of each stock is 150+10 = 160 Since shareholders get the same cash flow eventually, the shares must sell at the same price initially, i.e. dividend policy does not matter
Imputation system
Dividends are taxed as ordinary income but investors get a partial tax credit for corporate taxes (to offset personal taxes) Dividends are not tax deductible at corporate level
Dividend clienteles
Some investors do not pay taxes These investors will, everything else being equal, prefer high dividend yield firms to low dividend yield firms as they do not pay tax on the dividend Firms might adopt different dividend policies to attract different investor clienteles Empirical evidence suggests that investors portfolios have dividend yields that are related to their tax status (high tax bracket investors choose low dividend yield stocks and vice versa)
Price drop less than the dividend payment is also observed in countries that do not have a classical tax system, suggesting this is not a tax driven phenomenon at all
Readings
Grinblatt/Titman chapter 15
Exercises
1. A stock trades at 100p per share (prior to ex-dividend day) and the firm will pay a dividend of 10p per share.
a) b) c) d) e) Work out the ex-dividend day price if investors pay 40% tax on dividends and the ex-dividend day price equals the initial price less after-tax dividend payment Work out the minimum transaction cost per share that prevents tax-arbitrage by a tax-paying investor Suppose the dividend payment was 50p per share. What is your answer to a) and b) now? Suppose the actual transaction cost is 2p per share. What are the arbitrage free price drops in a) and c) above now? What are the implied tax rates on dividends in d)?
How such conflicts affect investment, financing, and ownership structure How such conflicts can be mitigated by executive compensation schemes
Bonus schemes not performance sensitive enough Changes in corporate governance have made managers more accountable in recent years
Ownership structure
Ownership structure is on the whole more concentrated than we would expect (CAPM advocates diversification), particularly outside the US/UK Ownership concentration a response to weak legal protection of shareholders interests UK/US have the strongest protection and the most diffuse ownership structure Managers tend to keep a significant ownership stake in firms where the incentive conflict with the shareholders is the greatest In many internet IPOs, the managers kept a large share of their holding in order to get a higher price in the IPO (lock in clauses) Eg. Lastminute.com Martha Lane-Fox and Brent Hoberman (founders Hoberman still manager) were still large owners after IPO and were prevented from selling their share for a given time period after the IPO Firms with higher concentration of management ownership have higher market values relative to their book values, provided management share is not too big. If it gets above 5%, managers become entrenched which allows them to pursue own interests more
Investments that reduce risk and increase the scope of the firm
To avoid bankruptcy the manager seeks relatively safe investments and may take a portfolio approach to investments
Debt is a good way to curb overinvestment Debt engages often a bank who is a good monitor of management
Executive compensation
The problem of incentivizing managers is often called a principal-agent problem
Tenant farmer works the land of a land-owner. If compensated too much in terms of output, the tenant farmer must bear all the risk influencing output (weather etc). If compensated too little in terms of output, the tenant farmer doesnt put in the required effort. Compensation is a matter of balancing the two concerns: Called the problem of designing the optimal incentive contract Effort (input) cannot be observed, otherwise compensation could be tied to effort instead of output Design objective is to minimize the agency costs of delegated control
Over time, the pay-for-performance sensitivity has been increasing Adoption of performance-based pay is generally a positive signal to the investors What about relative performance sensitivity (pay linked to the position of the company relative to the average for the industry)? Relative performancepay is rarely observed, but can be costly to investors in terms of price wars and overly aggressive competition. Stock-based performance versus earnings-based performance. Stock based performance is much noisier than earnings-based performance, but in return earnings can be manipulated by the manager
Readings
Grinblatt/Titman chapter 18
Exercises
1. The manager of a firm considers investing 1m of free cash flow (earnings currently held in a bank account) in a project that has private value 10,000 to the manager but NPV of 200,000 to the investors. What is the optimal decision for the manager if
a) He has fixed pay? b) He has in addition a bonus scheme where an increase of 1000 in the stock value leads to an increase of 10 to the manager? c) What is the optimal bonus scheme for the manager in this case?
Pooling: they act in a way that everybody else act in order not to reveal information
It is too expensive to send a signal
Manipulation
Actions: Investors overestimate the true cost of signalling Reporting: Bad reports attract attention it may be easier to disguise bad outcomes by submitting an average report
Earnings manipulation
The same underlying profits can be reported in different ways as earnings
Depends on the choice of depreciation method Choice of inventory valuation method (FIFO LIFO) The estimates of the economic value of assets, the estimates of the cost of guarantees or warranties issued, the estimates of the pension liability of the firm, the discount rates used for valuation of leases and pensions etc.
There is a tendency to inflate reported earnings to increase the current stock price But managers may also find it useful sometimes to deflate reported earnings
For instance when the manager has just been hired When applying for government subsidies or tariff protection against foreign competitors
Short-termism in investment
Bias towards short term projects because these makes it clear very quickly whether the investment is a good one Example:
Project A: yr 1 cash flow 40; yr 2-11 cash flow 80 per year; PV 840 Project B: yr 1 cash flow 60; yr 2-11 cash flow 50 per year; PV 560 Project C: yr 1 cash flow 40; yr 2-11 cash flow 40; PV 440
Investors think C is much more realistic than A or B If company chooses A, the stock price is close to 440 after yr 1 earnings are revealed, why? If company chooses B, the stock price is close to 560 after yr 1 earnings are revealed, why? Company has a disincentive to choose the best project which is A because it is too similar to C in the first year If managers seek to maximize the intrinsic value they should choose A regardless
An increase in dividends signals increased cash flow (as dividends then are more affordable) but is not consistent with an increase in investment opportunities (as they are then needed for investments) An increase/cut in dividends is, therefore, a more complex signal than is suggested in previous slides Empirical evidence suggests that cuts are viewed more favourably when the firms experience an increase in investment opportunities
Firms with poor prospects find it hard to mimic the same borrowing decisions
Empirical Evidence
Event study methodology Leverage increasing transactions (debt-for-equity swaps) have positive stock price response Leverage neutral transactions (debt-for-debt) have zero response Leverage decreasings (equity-for-debt) have negative stock price response Security sales (equity, debt) have negative stock price response, and more so for equity than for debt Empirical evidence is consistent with information theories (this week) but is also consistent with incentive theories (last week)
Adverse Selection
Sick people tend to see health/life insurance as cheap consequently they will be over-represented in the group of buyers of this type of insurance Example: very expensive insurance that covers 100% of all costs or cheap insurance that covers only 80% of all costs
In this case the sick people might migrate to the expensive type of insurance and the healthy ones to the cheap type
This is called adverse selection buyers or sellers do not always select themselves randomly but rather according to their type This also plays a role in the sale of corporate securities
Corporation can be expected to sell equity when the stock is overvalued and buy back equity when the stock is undervalued This makes sell transactions a bad signal and buy transactions a good signal This makes equity a bad source of capital for new investment, since it must be sold at a discount to the current stock price (why?) Pecking-order theory: firms prefer retained earnings to external capital, and external debt to external equity, when financing investments
Managers have inside knowledge and at the same time sell or buy corporate securities
Readings
Grinblatt/Titman chapter 19
Exercise
A firm has already made an investment and is considering an additional investment opportunity
State of nature is good or bad, equal probabilities. Assume risk neutral valuation with zero discount rates. Manager knows the true state of nature Current investment has value 150 (good) or 50 (bad) NPV investment opportunity is 20 (good) or 10 (bad) Currently the firm is financed by equity only It plans to issue equity to finance the new investment, which costs 100 To do:
Set up the balance sheet before and after investment @ expected values Work out how much of the existing equity the firm needs to sell in order to finance the investment Compare the value of the existing (old) equity with investment and without investment in the good and the bad state If the manager acts in the interests of the existing shareholders, should he always go ahead with investment. Explain.