Welcome everyone on the second week of the capitals markets course.
In the first week,
we analyzed problems caused by private information in
the built up simplified models and still
recognized that the existence of these problems produces a significant potential
or real damage to the efficiency of money movement around these markets.
And we realize that we have to somehow
cope with these problems and find instruments to alleviate them.
This week, we will make a short recap of
what happened before and then move on towards these instruments.
We said that moral hazard and adverse selection result in
the following problem that nice positive NPV and low-risk,
or in our models riskless projects,
get driven out of the market, projects or companies.
And that clearly is bad for efficiency.
I will start this weekend,
this first episode, with another former promised,
egregious example of how even a great project cannot find financing.
Well, let's go back to our classic setup.
Again, we have a high and low future state.
But this time, it will be just the only project.
And here is the probability pie,
and here is a cash flow.
Now, before we had half and half and then sometimes something high and zero,
now look what we have.
We have .80 in the high state and .20 in the low state.
First of all, we can see that the high state is much more likely.
And not only that,
but the cash flow here is 15,
and here it is five.
So we can see that actually although clearly in a low state,
the cash flow is much lower,
but it's not zero,
so we do not lose all the money in the low state.
Now, let's also pretend that in order to finance a project,
we need modest investment of 6 million dollars.
All numbers here are in millions.
Now let's calculate its NPV.
Well, it's quite clear that NPV is equal to .80
times 15 plus .20 times five.
Thats our expected cash flow.
We subtract initial estimate of six minus six,
and that gives us plus 7 million dollars.
It's a pretty cool project.
We can see that another important thing is,
look, we invest all the 6 million dollars,
if here, we had 6 or more,
then we could say that we recover our investment in all cases.
However, in the low state,
we do lose, but just 1 million dollars.
So clearly, this project has as a nice positive NPV and it has moderate risk.
Now, what I claim is that you cannot find equity financing for this project.
Well, first of all, What is equity financing?
Equity financing is a situation in which an investor comes in
and gives me the project owner some money.
And for this money,
he or she gets a claim on a portion of my future cash flows.
Well, we will later on this score stock a lot about equity investors.
But for now, it's an important model setup.
So, let me show that this great project cannot find equity investors.
Let's say that an equity investor is the one who claims all cash flow.
Now, the important thing is that if
this equity investor observes the actual state that tap on high or low,
then clearly that is doable,
but we live in the world of non-observeability.
So, although this is sort of a set up situation,
but it goes like this.
I am the project owner,
so only I observe which state high or low indeed occurred.
You are equity investors, so you give money.
You in the conference have these share of cash flow,
but you do not observe what happened.
Let's say for simplicity that you claim all cash flow.
Well, you can say it's kind of funny,
why the hell will I engage in this project?
I will show to you why right away.
Let's say that you claim this 100 percent cash flow.
Now, if the high state occurred,
you gave 6 million dollars and then you get 15.
Well, that's pretty cool. I get nothing.
But if indeed the low stay occurred,
unfortunately, you get only five.
You take all the money, but you still cannot recover your 6 million dollars.
Now see what happens?
Who observes the actual outcome? Only myself.
So I have a huge incentive to always declare to you that the low state occurred.
Let's say if a low state indeed occurred.
So you recover five,
you'll lose one million dollars,
I didn't have anything and I do have nothing.
However, if I claim to you will that the low state that occurred,
I have to give you back five.
But if indeed the high state occurred,
I give you five and then I pocket the remaining 10,
so I have a huge incentive to always lie to you.
Well, you can say this is unethical clearly,
this is bad clearly,
but that's exactly what I said.
Because in the case of unobserverability,
equity investors can not trust my words.
And therefore, unfortunately they can say, well, you know,
whatever happens, you always claim that L occurred and I lose money.
Sorry about that, I cannot participate in that.
Well, that's too bad and that's kind of
strange because we know that the capital markets has a lot of people.
We see them on the market for stocks and stocks are clearly parts of equity investments.
But again, we will see exactly how that develops.
But for now, we have to stop here and say,
well unfortunately, equity investment is not doable.
So, what will we do?
We will see that in the next episode.
