(Some theoretical aspects of) Corporate Finance

Transcription

1 (Some theoretical aspects of) Corporate Finance V. Filipe Martins-da-Rocha Department of Economics UC Davis Chapter 2. Outside financing: Private benefit and moral hazard V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

2 Outline of Chapter 2 A. The role of net worth: a simple model of credit rationing B. Debt overhang C. Borrowing capacity: the equity multiplier D. Semiverifiable income Holmström, B. and Tirole, J. Financial intermediation, loanable funds, and the real sector Quaterly Journal of Economics 112, 1997 V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

3 Part A The role of net worth: a simple model of credit rationing V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

4 The fixed-investment model: the entrepreneur An entrepreneur (the borrower or insider) has a project which requires a fixed investment I The entrepreneur has assets (cash in hand) A < I that can be invested or consumed To implement the project, the entrepreneur needs to borrow at least I A from lenders V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

5 The fixed-investment model: the project If undertaken, the project may succeed and yield verifiable income R fail and yield no income The entrepreneur can behave or misbehave behave: work, exert effort, take no private benefit misbehave: shirk, take private benefit Behaving yields probability p h of success and no private benefit to the entrepreneur Misbehaving yields a probability p l < p h of success and private benefit B > 0 to the entrepreneur. The private benefit can be interpreted as a disutility of effort saved by the entrepreneur by shirking We let p = p h p l V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

6 Private benefit Another possible interpretation of private benefit is as follows: the entrepreneur chooses between a project with a high probability of success and another project which he prefers because it is easier to implement is more fun benefits a friend delivers perks is more glamorous V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

7 The fixed-investment model: preferences Implicitly there are two time periods t {0, 1} At t = 0 the investment occurs (and agents consume) At t = 1 the project yields income (and agents consume) Both type of agents, investors and entrepreneurs have no time preference and are risk neutral, i.e., U(c 0, c 1, Q) = c 0 + E Q [c 1 ] where Q is the objective probability on exogenous uncertainty (success or failure) that may depend on the entrepreneur s action (behave or not) { ph if the entrepreneur behaves Q(sucess) = if the entrepreneur does not behave p l V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

8 The fixed-investment model: lenders The rate of return expected by investor is 0 (they are indifferent between consuming today or tomorrow): The investor is willing to lend 1 at t = 0 in exchange of a random stream w = (w success, w failure ) satisfying E Q [w] = 1 Several (perfect competition) prospective lenders compete for issuing a loan to the borrower If there is a loan offer, it must maximize the entrepreneur s payoff under the participation constraints Otherwise the borrower could turn to an alternative lender V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

9 The fixed-investment model: sharing income There is limited liability for the borrower: both sides receive 0 in case of failure In case of success, the two parties share benefits Rb 0 goes to the borrower R l 0 goes to the lender Nothing is lost: R = R b + R l There is an incentive scheme for the entrepreneur: R b in case of success, 0 in case of failure V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

10 The fixed-investment model: the timing 1 Loan agreement (sharing rule) 2 Investment 3 Moral hazard: entrepreneur s behavior 4 Outcome and benefit sharing V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

11 The fixed-investment model: net present value We assume that the project is viable only in the absence of moral hazard, i.e., we assume that the project has positive NPV if the entrepreneur behaves, p h R I > 0 the project has negative NPV if the entrepreneur does not behave, even including private benefit, p l R I + B < 0 As a consequence, the entrepreneur and the lender cannot agree on a loan that gives an incentive to the borrower to misbehave since for any sharing rule (R b, R l ) [p l R l (I A)] + [p }{{} l R b + B A] < 0 }{{} lender s NPV borrower s NPV V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

12 The lender s credit analysis The loan contract should provide incentives to the entrepreneur for behaving Assume that agents agree on a loan contract (R b, R l ), the borrower faces the following tradeoff misbehaving to get the private benefit B but this reduces the probability of success: the expected return is p l R b + B behaving, in that case the expected return is p h R b V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

13 Incentive compatible constraint The loan contract (R b, R l ) is granted only if the following incentive compatible constraint is satisfied: p h R b p l R b + B or ( p)r b B The entrepreneur stake in the firm s income should be large enough The highest income that can be pledged to the lenders without jeopardizing the borrower s incentive is then R B p and the expected pledgeable income is then ( P = p h R B ) p V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

14 Individual rationality constraint In order to be willing to finance the project, the following individual rationality constraint should be satisfied ( P p h R B ) I A p This constraint is also called breakeven constraint or participation constraint V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

15 Necessary condition A necessary condition for the financing to be arranged is We will assume that A A = p h B p (p hr I) A > 0 p h R I < p h B p the NPV if the borrower behaves is smaller than the minimum expected rent that must be left to the borrower to provide him with an incentive to behave The borrower must have enough assets in order to be granted a loan V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

16 Credit rationing: assume A < A The project may have positive NPV and yet it cannot be financed With insufficient assets, the entrepreneur must borrow a large amount and therefore pledge a large fraction of the return in case of success The entrepreneur then keeps a small fraction of the income and is demotivated The two parties cannot find a loan agreement that both induces effort allows lenders to recoup investment There is credit rationing, the borrower may be willing to give a high fraction of the return to the lenders, i.e., pay a high interest rate but the lenders do not want to grant such a loan V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

17 Sufficient condition Assume that the borrower has enough assets, i.e., A > A then the entrepreneur can secure financing The entrepreneur offers claim R l to competitive investors so as not to leave them with a surplus: The entrepreneur stake is then p h R l = I A R b = R R l = R I A p h and induces him to behave One only lends to the rich R I A p h = B p V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

18 Agency rent Recall that A = p h B p (p hr I) B The term p h p is the minimum expected monetary payoff to be left to the borrower to preserve incentives. This is called the agency rent The term p h R I is the expected monetary profit of the project The borrower should make a sufficiently high initial contribution A to reduce the agency rent p h B p below the expected monetary profit (p h R I) + A V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

19 Expected net payoff If we define Π b the expected net payoff (of the borrower) by subtracting the consumption utility A to the expected payoff, then we get { 0 if A < A Π b = p h R b A = p h R I if A A By the competition hypothesis, lenders have zero profits and the borrowers perceive the entire social surplus or NPV if the project is funded V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

20 Full investment of entrepreneurial assets Consider that the borrower consumes c A and invests only A c If the project is still funded, the borrower still obtains the entire NPV, i.e., p h R I However, it becomes more difficult to obtain a loan since A should now exceed A + c Therefore, the entrepreneur cannot gain by not investing her entire wealth in the project But the project may not be funded if c is such that A c < A V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

21 Dilution and overborrowing: deepening investment Assume that the project is funded through a loan contract (R b, R l ) where the borrower s stake satisfies the incentive-compatibility constraint R b B/ p Suppose there is an opportunity for deepening investment the new investment costs an extra J it increases the probability of success by τ Assume that this deepening investment is inefficient in the sense that its net cost C 1 is positive, i.e., C 1 J τr > 0 V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

22 Covenants Usually, the debt contract with the initial lenders includes covenants prohibiting the dilution of creditor s through the issue of new securities. There are two reasons Lenders don t want the borrower to issue claims that have a higher seniority as theirs, as this reduces the amount they can collect More subtle, the issue of new securities may alter managerial incentives and then the probability of success V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

23 Dilution and overborrowing: timing 1 Borrower has wealth A and borrows I A from initial lenders. The loan contract allocates the return R (in the case of success) between borrower R b and lenders R l 2 Borrower can contract with new lenders to finance deepening investment J. If so, the new loan contract allocates the stake R b between the borrower R b and new lenders R l 3 Moral hazard: the borrower behaves (p = p h and no private benefit) or misbehaves (p = p l and private benefit) 4 Outcome: success with probability p + τ or failure with probability 1 p τ V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

24 Overborrowing and managerial incentives The new investment reduces the total value by C 1. Someone must loose in the process. The borrower cannot still behave. If he behaves, the expected value of initial investors claim is increased to (p h + τ)r l Either the new lenders loose or the borrower looses. It cannot be the new lenders, otherwise the new loan would not be funded The borrower misbehaves and there is another cost C 2 = ( p)r B V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

25 Gains from overborrowing In case of success, the borrower s stake R b is diluted into R b + R l Assuming that the new lenders are competitive, then (p l + τ) R l = J The entrepreneur gains from overborrowing if or equivalently (p l + τ) R b + B > p h R b [(p l + τ)r b J] + B > p h R b or [p h (p l + τ)] R l > C 1 + C 2 V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26

26 Interpretation The term C 1 + C 2 is the total cost of refinancing: direct cost plus incentive cost The term [p h (p l + τ)] R l is the (negative) externality on the initial investors Recall that R b = R (I A)/p h If the borrower s balance sheet measured by A improves, R b increases and R l decreases The sufficient condition for reinvestment is less likely to be satisfied In the absence of negative covenants, overborrowing is more likely to happen with weak borrowers V. F. Martins-da-Rocha (UC Davis) Corporate Finance Spring quarter, / 26