Important Flashcards
Debt Overhang
Shareholders forgo positive NPV projects. aka Under-investment due to debt overhang
“debt overhang,” you might think of it as a heavy cloud of debt looming over a company, casting a shadow on new opportunities
Debt overhang occurs when a company has a large amount of existing debt, which discourages further investment in the company, even for new, potentially profitable projects. This is because the benefits of the investment primarily accrue to the debt holders rather than to the equity holders. As a result, the company might pass on new opportunities, potentially stunting its growth. This situation is problematic because it can lead to a suboptimal investment strategy that hinders the company’s long-term potential.
Risk Shifting
Shareholders prefer excessively risky projects.
Equity holders favor high-risk/high-reward projects. If successful, shareholders gain significantly, while failure impacts debt holders due to their fixed claims.
Leverage Ratchet
due to Debt Overhang
When debt levels are high, shareholders may not invest in new, positive NPV projects since debt holders would capture much of the investment’s value, leaving less for shareholders. This leads to a suboptimal level of investment from the firm’s perspective.
The term “leverage ratchet” can be envisioned as a tool that only turns in one direction, ratcheting up the leverage without the ability to easily reverse it. Just as a ratchet wrench tightens but doesn’t easily loosen, in financial terms, once leverage is increased, shareholders may find it disadvantageous or difficult to decrease it, even when it might be beneficial to do so.
How do you calculate expected transition loss?
Integrated value formula
Consumer surplus formula and
customer wellbeing value flow
value flow = (sales / price elasticity) x 0.5 x 50% atribution
Price elasticity = delta Q/Q / delta P/P
What are the IPO puzzles
and what solves them?
- IPO underpricing (underwriter set the issue price so that avg first day return is positive, winners curse)
- High IPO/SEO underwriter fees (7% of issue prive, to signal quality of underwriter)
- Cyclicality in IPOs (due to the supply of capital)
- Negative stock price reaction to SEOs
- Adverse selection can help explain IPO/SEO puzzles
What is adverse selection
adverse selection can occur when sellers have more information about the value or risk of an asset than buyers do. This can result in the market becoming more populated by lower-quality goods, as the sellers of high-quality goods are not willing to accept the same prices as sellers of lower-quality goods. Buyers, aware of this possibility, might be less inclined to engage in the market, which can lead to market failure.
What are the rules of an integrated balance sheet?
You can make an integrated balance sheet. Remember the rules for SV and EV are:
* positive value = assets
* negative value = debt
* assets – debt = equity
* equity can be negative (when debt is bigger than assets)
What is the agency/moral hazard benefits of debt
NPV formula for Vh and Vl state (without equity incentive)
Think of B
Tax shield formula
(corporate tax rate) x (interest parmants)
Financial vs Economic Distress
- A firm that makes significant losses is in economic distress
- Whether economic distress results in financial distress depends on the firm’s leverage
- An all-equity (unlevered) firm can be in economic distress, but it will never face bankruptcy
What is the participation constraint formula (PC)
How much e stake does entrepeneur need to participate -> break even for investors
What is the incentive compatibility (IC) constraint formula
