2.1. Infeasibility of equity financing in the presence of unobservability

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From the course by Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 оценка

Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 оценка

Course 1 of 5 in the Specialization Understanding Modern Finance

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

From the lesson

ALLEVIATION OF MORAL HAZARD – DEBT AND EQUITY CONTRACTS. BANKS (1) – DIVERSIFICATION AND MONITORING

In Week 2 we will consider certain ways of overcoming problems caused by private information and evaluate them. We will know why some methods work while others don’t, and why. You will learn the core differences between equity and debt financing, study debts contracts with liquidation and see the core inefficiency of that kind of a debt contract. Based on a simple model you will study diversification and delegated monitoring and see how they contribute to the efficiency of lending. We will find out how a bank emerges as a key financial intermediary responsible for asset monitoring. You will be able to see why the bank can make money and to calculate its profit in different cases. At the end of Week 2 we will pose a fundamental question: How does the bank attract depositors?

2.1. Infeasibility of equity financing in the presence of unobservability7:11

2.2. Debt contract with liquidation (DCL) as a means of alleviation of moral hazard. The inefficiency of DCL6:41

2.3. Monitoring as a universal and efficient way of overcoming unobservability5:20

2.4. Multiple lenders (1) – the model8:19

2.5. Multiple lenders (2) – bank contracts5:15

2.6. Delegated monitoring (1) – the interaction of the parties and bank’s profit12:09

2.7. Delegated monitoring (2) – banks’ vulnerability to runs5:21

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

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.

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