1. Introduction

Question 1

Before the 1970s what model was used?

Answer 1

Arrow-Debreu general equilibrium model of frictionless markets

Question 2

What were the assumptions of the Arrow-Debreu general equilibrium model of frictionless markets?

Answer 2

Perfectly competitive and complete markets (so complete insurance is possible)
No transaction costs
No bankruptcy costs
No informational asymmetries

Question 3

According to the Modigliani- Miller theorem, in the Arrow Debreu economies, how does a firms financial structure work?

Answer 3

A firms financial structure, its choice of the level of leverage (debt) or dividend policy is irrelevant. Put differently, the size of the pie is unaffected by the way it is carved

Question 4

How can we evaluate the Arrow-Debreu model?

Answer 4

Powerful tool for analysing the pricing of claims but is unable to make predictions about:
Financial structure
Intermediation
And their relationship with economic activity

Question 5

How does Moral hazard affect corporate finance?

Answer 5

Lenders can’t observe the borrowers carefulness in selecting projects, the riskiness of investments, or the effort they exert to make the firm profitable

Question 6

Adverse selection

Answer 6

Borrowers have private info about exogenous environmental variables at the date of contracting

Question 7

Hidden knowledge

Answer 7

Borrowers acquire private info about exogenous environmental variables after contracting

Question 8

What are assets?

Answer 8

What an entity owns

Question 9

What are liabilities?

Answer 9

What an entity owes?

Question 10

What is equity equal to?

Answer 10

Assets - debt

Question 11

When is a firm insolvent?

Answer 11

When equity is negative. Ie debt is larger than assets

Question 12

What does the Modigliani-Miller theorem say about the value of a firm?

Answer 12

It depends only on its investment policy and not on the dividend and capital market choices

Question 13

What are the four categories that moral hazard can be split into

Answer 13

Insufficient effort
Extravagant investments
Entrenchment strategies
Self dealing

Question 14

What do extravagant investments refer to?

Answer 14

Managers building pet projects to the detriment of shareholders

Question 15

What are entrenchment strategies?

Answer 15

Actions to keep one’s position safe

Question 16

What is self dealing

Answer 16

Increasing private benefits with self dealing behaviour

Question 17

How can debt be used as an incentive mechanism?

Answer 17

-tax advantages
-by taking cash out of the firm it prevents managers from consuming it
-managers must contemplate their future obligation to pay creditors on time

Question 18

Limits to debt as a governance mechanism

Answer 18

-cost of illiquidity- may deprive firm of liquidity needed to finance ongoing and new projects. The firm may not be able to insure at a reasonable cost against exogenous shocks
-bankruptcy costs- inability to pay debt coupons may push it into bankruptcy

Question 19

Evaluation of graphs of debt and equity

Answer 19

-the firm is usually an ongoing entity which produces a stream of returns rather than a single one. The one dimensional representation is at best a condensed view of the stream of returns attached to the claim.
-is the debt held by a large player such as the bank or by dispersed investors?
-debt may be decomposed into ordinary debt and secured debt

Question 20

Convertible debt

Answer 20

Debt that it’s holders can exchange for the firms shares at some pre-determined conversion rate. Some argue this option protects debt holders against excessive risk taking by the firm

Question 21

5 C’s of credit

Answer 21

Character, Capacity, Capital, Collateral, Coverage