Equity Finance

Question 1

When d* > pbar (Rho) in Equity Finance, what can Type 1 do?

Answer 1

Offer Equity in their project for funding

• Overcomes Adverse Selection - projects all have Same Exp. Value (Gross Return)
• • All projects are Equally Attractive

Question 2

How is K raised in Equity Finance?

Answer 2

Entrepreneurs offer N Shares

• Prices of Shares = Vi
• • NVi = K

Question 3

What is the Participation Constraint of Investors in Equity Finance?

Answer 3

Vi ≥ K / N

Question 4

How is Share Price calculated?

Answer 4

Shareholders pay Vi - Receive E(R)/N
– Alternatively could save + earn Vi(1 + d)
THEREFORE: Vi = E(R) / N(1 + d)
E(R) is Same for both Projects –> V1 = V2 = V

Question 5

When is Participation Constraint satisfied?

Answer 5

When Type 2 Entrepreneurs make Positive Return under Debt of Equity
- E(π2)debt or E(π2)equity ≥ 0

Question 6

Given N=100 and E(R)/100(1 + d*) ≥ K/100, what is Type 2’s Participation Constraint and what does it mean?

Answer 6

[p2R2 + (1-p2)K]/100(1 + d) ≥ K/100
=> p2R2/(1 + d) ≥ K [1 - (1-p2)/(1+d)]
==> p2R2/(1 + d) ≥ K [(1+d-1+p2) / (1+d)]
=> p2R2 ≥ K (1 + d* -1 + p2)
==> p2R2 ≥ K (d* + p2)
=> p2(R2 - K) ≥ Kd* - Type 2 Indifferent between offering Equity + Using debt when r = d*/p2

Question 7

What is Type 2 Expected Profit from Debt?

Answer 7

E(π2)debt = p2[R2 - (1+r)K]
==> p2R2 - p2(1 + d/p2)K
=> p2R2 - (p2 + d)K

Question 8

What is Type 2 Expected Profit from Equity?

Answer 8

E(π2)equity = E(R) - (E(R)/100)(K/V)
= E(R) (1 - K/100V)
Since Vi = E(R)/100(1+d*)
E(R) [1 - (K x 100 x (1+d*)) / (E(R) x 100)]
= E(R) [(E(R) - (1 + d*)K) / E(R)]
= p2R2 - (p2 + d*)K 
-since E(R2) = p2R2 + (1-p2)K

Question 9

What is Credit Rationing?

Answer 9

occurs when Asymmetric Info means Credit must be Rationed amongst Borrowers despite availability of enough funds to Finance all projects that Banks would not make a Loss on
- Requires Supply of Loans to be Positively Sloped- not Infinitely Elastic

Question 10

Equilibrium in Loans Market, what is the outcome of Case 1: 2 Intersections between Supply and Demand for Loans?

Answer 10

2 Possible Eq. - 1 Above and 1 Below Discontinuity Point
– Below Discontinuity point –> Lower r + Higher Q –> Increased p (Rho) and Higher d
Efficient Outcome - All Banks driven to Lower r by Competition

Question 11

Equilibrium in Loans Market, what is the outcome of Case 2: 2 Intersections between Supply and Demand for Loans w/ Credit Rationing due to Excess Demand at B?

Answer 11

2 possible I.R - 1 Above + 1 on Discontinuity point
Inefficient Outcome - funds are available for whole Market at r2 (Highest I.R)
– Sl > (n1 + n2)K

Question 12

Equilibrium in Loans Market, what is the outcome of Case 3: 1 Intersection between Supply and Demand for Loans?

Answer 12

Intersection beyond Discontinuity point

Only Type 2 are Funded - Inefficient Outcome

Question 13

Why does Equity solve Credit Market Issues?

Answer 13

Buyers of Shares only worry about Exp. Return which is equalised across all Projects

Question 14

Equilibrium in Equity Market, Outcome in Case 1: High Demand for Shares?

Answer 14

Efficient Outcome - all projects that want funding can get it
V > K/N

Question 15

Equilibrium in Equity Market, Outcome in Case 2: Low Demand for Shares?

Answer 15

Projects can’t offer sufficient Returns to attract funds

• Excess Supply of Shares + Rationing
• • But NO INEFFICIENCY