Economics and Finance,

Transcription

1 Economics and Finance, Lecture 5 - Corporate finance under asymmetric information: Moral hazard and access to external finance Luca Deidda UNISS, DiSEA, CRENoS October 2014 Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

2 Plan Introduction Model Equilibrium Rationing Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

3 Corporate finance under perfect capital markets What does perfect capital markets mean? Perfect capital markets imply Irrelevance of the separation between ownership and control Irrelevance of financial structure (Modigliani and Miller irrelevance result, see lecture 4 and Problem set 1) What does perfect capital markets mean? No transaction costs, and no informational frictions Agents can write complete contracts: i.e. contracts that establish ex ante the allocation of property rights over all future cash flows of the firm in any possible contingent event This is not what reality is about Information is incomplete and asymmetric: as a result, contracts are incomplete Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

4 Asymmetric information and corporate finance Corporate finance under asymmetric information As we shall see, asymmetric information has profound implications on firm s governance Potential conflict of interests arise, which are costly to deal with Inefficiencies The design of appropriate incentive mechanisms becomes key to the good governance of a firm and therefore to its success In this part of the course, we shall analyze a variety of issues arising due to: Informational asymmetries ex post: Moral hazard Informational asymmetries ex ante: Adverse selection Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

5 Moral hazard and rationing Concept of credit rationing Definition (Credit rationing) [..]A would be borrower is said to be rationed if he cannot obtain the loan he wants even though he is willing to pay the interest the lenders are asking, perhaps even a higher interest rate [..] (Bester and Hellwig, 1987, Moral Hazard and Credit Rationing: An overview of the issues. In, Agency Theory: Information and Incentives, (Ed. Bamberg and Spremann). Heidelberg: Springer. For a more general definition, replace the word credit with the word external finance We shall show that credit rationing is the result of informational asymmetries Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

6 Empirical evidence Moral hazard and rationing Survey on Small Business Finance (SSBF), US 11% of firms over total is discouraged or rationed This means 22% of those firms that demand credit Note: this underestimates the phenomenon Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

7 Moral hazard and rationing Credit rationing and asymmetric information As the interest rate increases, the residual cash flow that can be appropriated by the firm-owner (entrepreneur) is reduced As a consequence Entrepreneurs might pursue private interests rather than try and maximize firm s value: Moral hazard Safer entrepreneurs might be discouraged from applying for credit relatively to riskier ones: Adverse selection Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

8 Moral hazard and rationing Moral hazard and access to external finance In this lecture we will analyze how moral hazard affects firms access to credit (or more generally external financing) Subsequently we will extend the model to analyze a number of corporate finance issues Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

9 Model The model Model s ingredients: Agents: preferences and endowments Investment technology Market for financial resources Time horizon Information Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

10 Model Agents: preferences and endowments; Time horizon One entrepreneur (insider, potential borrower) He is risk-neutral Owns and manages the firm Owns an amount A of financial resources Third financial investors (Lenders) They face an opportunity cost of lending, r They are risk-neutral Financial resources are abundant Time horizon: Two dates, 0, and 1 Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

11 Model Production technology The entrepreneur has access to an investment project of fixed size I that yields R at the end of the period, with probability p and 0 with probability 1 p A < I holds, hence the entrepreneur needs financial resources R is observable and verifiable The probability of success depends on entrepreneurial effort: it equals p H if the entrepreneur exerts high effort and p L if the entrepreneur exerts low effort Effort is not observable and not verifiable Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

12 Model Moral hazard If exerting low effort in the conduct of the firm, the entrepreneur can pursue private benefits B Private benefits are not observable and not verifiable If exerting high effort in the conduct of the firm, private benefits equal zero We assume: p H R 1 + r > I > p R L 1 + r Moral hazard: As the residual cash flow that the entrepreneur can appropriate after payments to third investors falls, the entrepreneur might develop the incentive to misconduct the firm and pursue private benefits (1) Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

13 Model Financing contract The financing contract establishes if the entrepreneur s project is financed or not The amount, I A The overall financing cost, defined as R L Implicitly, it also defines the residual cash flow appropriated by the entrepreneur, which is given by: R B : R B + R L = R R B = R R L (2) Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

14 Model Sequence of events and equilibrium concept Time 0 Stage 0: Loan agreement (we can think that lenders offer the contracts ) Stage 1: Investment takes place Stage 2: Entrepreneurs privately choose effort Time 1: Payoff are realized Definition (Equilibrium) An equilibrium in pure strategies is defined as a contract and a set of strategies for lenders and borrowers such that: Strategies are optimal given opponent s best reply at any stage of the interaction Lenders make zero expected profits Task: We need to find the equilibrium contract Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

15 Model Incentives If the project is financed, the contract should give the entrepreneur the incentives to choose high effort This implies guaranteeing him some stake R B > 0 of firm s cash flow How much? Enough to satisfy his incentive compatibility constraint Incentive compatibility constraint: Given a contract, If the entrepreneur chooses low effort gets: pl R B + B If the entrepreneur chooses high effort gets: ph R B Incentive compatibility requires: (ICC B ) : p H R B p L R B + B R B B p (3) Accordingly we can define the concept of pledgeable income: P = p H (R B p ) (4) Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

16 Model Characteristics of the optimal contract If the contract states that the entrepreneur is financed, then the contract ensures the right incentives as to induce a high level of effort, so that p = p H Competition among lenders implies that the equilibrium contract satisfies: p H R L = (1 + r)(i A) R L = (1 + r)(i A) p H (5) Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

17 Who is rationed? Rationing as the equilibrium result of moral hazard By definition, the pledgeable income is the maximum amount of income that an entrepreneur can credibly promise to pay external financiers without loosing the incentive to exert high effort Therefore, a necessary condition for an entrepreneur to be financed is P (1 + r)(i A) A A I P 1 + r (6) That is, the necessary condition for an entrepreneur to be financed is that the entrepreneur has enough internal financial resources Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18

18 Rationing as the equilibrium result of moral hazard Role of internal resources In the presence of informational asymmetries, the fact that the entrepreneur has access to a project that can guarantee a positive NPV is not enough to be granted external financing The problem is that the financial structure of the firm affects entrepreneurial private decisions in a way which can be detrimental to external financiers This is more likely to be the case if the financial structure is too skewed toward external financial resources Possible interpretations of the conflict of interest Debt vs equity External vs internal equity Luca Deidda (UNISS, DiSEA, CRENoS) EF October / 18