Equity Market

Question 1

What is the problem w/ Debt Finance in Hidden Action?

Answer 1

May have to set I.R so high - Gives Entrepreneurs Incentive to Invest in wrong type of project

Question 2

What is Equity Finance?

Answer 2

Entrepreneur gains % of Project’s Gross Returns

• Can be induced to carry out project w/ Greater Exp. Gross Returns
• • Incentive Compatibility occurs at Any Share Price

Question 3

What 3 things must we show for Equity Contracts to work?

Answer 3

1. Participation Constraint is Satisfied by V1
2. E(π1)equity ≥ E(π2)debt
3. E(π1(S1))equity ≥ E(π2(S1))equity

Question 4

What does Participation Constraint is Satisfied by V1 mean?

Answer 4

Price funders pay for shares is acceptable to Entrepreneur if they Invest in Type 1 project

Question 5

What does E(π1)equity ≥ E(π2)debt mean?

Answer 5

Entrepreneurs prefer to raise Equity to fund Type 1 than accept Debt to fund Type 2

Question 6

What does E(π1(S1))equity ≥ E(π2(S1))equity mean?

Answer 6

Funding Type 1 by Equity is INCENTIVE COMPATIBLE

- Won’t raise K selling Shares in Type 1 then Invest in Type 2

Question 7

Define S1

Answer 7

S1 = % of Project Entrepreneur retains after selling shares to fund Type 1 project
- S1 = [100 - (K/V1)] / 100 (Percentage)
- S1 = [No. of Shares offered - No. of Shares to be sold] / 100
If they invest these funds into Type 2 - still hold S1 shares

Question 8

What are they Exp. Returns if entrepreneur holds S1 shares?

Answer 8

S1 x E(R1)

Question 9

What are they Exp. Returns if entrepreneur holds S1 shares & Cheats?

Answer 9

S1 x E(R2)

Question 10

Under Market Collapse, what changes and assumptions do we make to the model?

Answer 10

• Different Returns (R1s > R2s)
• Different Costs (K1 > K2)
• Both Yield 0 if Unsuccessful
  => p2R2s = K2 - Type 2 Yields 0 Exp. Net Return
  => p1R1s - K1 > dK1 - Type 1 Exp. Net Return outweighs Market Cost of Funds
  -Infinite Supply of Funds at d

Question 11

How do we know if there will be a market for Type 1 Shares using V1 ≥ K1 / 100 under Full Info?

Answer 11

V1 ≥ K1 / 100 => [E(R)/100(1+d)] ≥ K1/100
==> E(R) ≥ (1+d)K1 => p1R1s - K1 ≥ d*K1
- Holds by assumption

Question 12

How do we know if there will be a market for Type 2 Shares using V2 ≥ K2 / 100 under Full Info?

Answer 12

V2 ≥ K2 / 100 => p2R2s - K2 ≥ d*K2
- Does NOT Hold by Assumption - Won’t be funded
Market has NOT Collapsed - Efficient one still open

Question 13

Under Incomplete Info, when will Entrepreneur Sell shares in Type 1 and Invest in Project 2?

Answer 13

Retain S1 in Type 2 project

• Do this if ICC does NOT HOLD
• • E(π1(S1)) < E(π2(S1))

Question 14

What is the new ICC for Market Collapse w/ Incomplete Info and why?

Answer 14

K1 > K2 - raising K1 but only spending K2 –> Gains Entrepreneur K1 - K2
ICC: S1 x E(R1) ≥ S1 x E(R2) + (K1 - K2)
Market Collapses if this does NOT HOLD

Question 15

Why does Market Collapse if ICC: S1 x E(R1) ≥ S1 x E(R2) + (K1 - K2) does Not Hold?

Answer 15

Funders know Entrepreneur will Invest in Type 2

- Do not wish to fund the project

Question 16

What are 2 possible Solutions to prevent Market Collapse for Equity?

Answer 16

• Law

- Monitoring

Question 17

How can the Law prevent Market Collapse?

Answer 17

Fraud is Criminal Offence - ICC holds if large enough Punishment imposed when R2 is Observed
ICCp: S1 x E(R1) ≥ S1 x E(R2) + (K1 - K2) - P
-BUT Dist. of Project Returns Overlap- hard to be sure R2s is due to Type 2

Question 18

How can the Monitoring prevent Market Collapse?

Answer 18

Monitor Entrepreneur Behaviour - e.g. Shareholders as Board Members

Question 19

What is more Efficient, Equity or Credit Market?

Answer 19

Equity Market is More Efficient