Ch 8 Analysis of Financial Structure
Ch 8 Analysis of Financial Structure ECON 3303
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This 6 page Class Notes was uploaded by Ashlie Meckley on Wednesday October 28, 2015. The Class Notes belongs to ECON 3303 at University of Texas at Arlington taught by Chi-Young Choi in Summer 2015. Since its upload, it has received 66 views.
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Date Created: 10/28/15
Ch 8 Analysis of Financial Structure Lecture October 13th 20th 8 basic facts of financial structure 1 Stocks are not the most important sources of external financing for business 2 Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations 3 Indirect finance is many times more important than direct finance 4 Financial Intermediaries are the most important source of external funds 5 The financial system is among the most heavily regulated sectors of the economy o Asymmetric problem 6 Only large well established corporations have easy access to securities markets to finance their activities 7 Collateral is prevalent feature of deb contracts 0 Student loans have no collateral 8 Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on barrowers Two Main Problems in Financial Markets 0 Transaction Costs 0 Maior Problems in Financial markets I Min face value I Brokerage commission fee for stock trade I Legal fees 0 Financial intermediaries I Reduce transaction cost o Economies of scale more you produce cheaper selling in bqu 0 Ex I Mutual funds I Class price decrease a increase of of enrollment in class I Costco cheaper cause you buy in bulk o Expertise 0 Ex MMMF provides liquidity 0 Problems with Asymmetric Information Bottom of every financial crisis Cannot be eliminated Specialized in loan offices Party s having insufficient knowledge about the other party Agency Theory OOOO Analyses how asymmetric information problems affect economic behavior by interfering with the efficient functioning of financial markets Adverse Selection Problem 0 Before transaction 0 Cannot tell good borrower from bad barrower o Lemons Problem 0 George Akerlof 0 Lack of information can lead to poor function market 0 Ex Car buyers do not know about the car as much as the seller does I Good Car Peach willing to pay 10000 I Bad Car Lemon willing to pay 4000 I Average of both is 7000 o Shouldn t buy the 4000 car for 7000 and can t buy the 10000 for 7000 I No purchase I Car dealers a bankers of market 0 Ex Banks and interest rates I Good investor 3 interest rate I Bad investor 15 interest rate I Average of both is 10 0 Good investor is not happy with this 0 Bad investor is o If the quality cannot be assessed the buyer is willing to pay at most a price that reflects the average quality I Good quality items will not want to sell at average price I Buy won t buy below average 0 Explains fact 2 and partially 1 0 Solutions 1 Private Production amp Sale information I Companies distinguish good from bad I Cant exclude free rider problem I Ex Angies list 2 Government Regulation to increase information I Security amp Exchange Commission SEC I Lessens adverse problem I Releasing negative info about firms can be politically difficult I Explains Fact 5 3 Financial Intermediation I Difficult obtaining information due to cost m out good credit risk from bad ones Can avoid free rider problem by primarily making private loans 0 can exclude information sharing smaller role of securities in developing countries EX buying from a dealer rather random person they have people who have evaluated car Explain Facts 34 amp 6 4 Collateral and net worth Moral Hazard Problem Collateral property promised to the lender if the borrower defaults Net Worth equity capital difference between a firms assets and its liabilities Lenders more willing to make loans secured by collateral and high net worth Explains Fact 7 0 After transaction 0 Cannot monitor how good your money is used 0 Ex People neglect to be careful with insurance 0 PrincipalAgent Problem 0 Separation of ownership and control of the firm Managers pursue personal benefits and power rather than the probability of the firm Ex Enron Scandal 0 Solutions Monitoring 0 Can t prevent free rider problem and costly 0 Explain Fact 1 Government Regulation 0 Impose criminal penalties o Explains Fact 5 Financial Intermediation o Venture Capital Firm pool the resources to help budding entrepreneurs start new business 0 Place their own people in the board of directors to monitor 0 Equity firm is marketable only to venture capital firm I prevents freerider problem 0 Explain Fact 3 0 Debt Contracts 0 Less severe problem of moral hazard than equity Explains Fact 1 Not free from moral hazard problem Barrowers have incentives to take on projects that are riskier than the lenders would like 0 Solution to Moral Hazard Prob I Net worth and Collateral incentive compatible I Monitoring and Enforcement of Restrictive Covenants provisions in contract to restrict I Financial Intermediation 0 Conflict of Interest 0 Moral hazard prob due to economies of scope multiple product of production 0 multiple objectives and as results has conflict 1 reduces the quality of info in financial markets 2 increases asymmetric information problems 3 deteriorates the function of financial market in channeling funds into productive investment opportunities 4 Lowers economic efficiency 0 Why they arise 1 Underwriting research in investment banking 0 Bank is attempting to simultaneously serve two client groups 0 Spinning allocates hot but underpriced IPO s to other companies for future business 2 Auditing and Consulting in Accounting Firms 0 Maybe willing to skew judgment to win consulting business 0 Ex Arthur Anderson amp Enron o Remedies 1 SarbanesOxley act of 2002 0 Public accounting return on investor protection act 0 Increase supervisory oversight to prevent conflict of interest 0 Made public company accounting oversight board 0 Increases SEC budget 0 No nonaudit service to a client contemporaneously with an impermissible audit 2 Global Legal Settlement 2007 0 Investment banks have to serve the link between Review Questions True False Questions 1 2 3 4 5 Stocks are the most important sources of external financing for business Banks are the more important source of external funds than stock and bond markets together The financial system is among the most heavily regulated sectors of the economy nsured drivers are more careful in driving than uninsured drivers Loan documents are generally bulky to prevent asymmetric problem Multiple Choice 1 Which of the following is the least important external funds for firms a Junk Bonds b Loans c Stocks d Municipal Bonds What is the primary source of external funds a Junk Bonds b Loans c Stocks d Municipal Bonds Which of the following is an accurate difference between Adverse Selection and Moral Hazard Problem a Moral hazard is an asymmetric problem while adverse selection is a transactional cost problem b Adverse selection is an asymmetric problem while moral hazard is a transactional cost problem c Moral hazard problem happens before a transaction and adverse selection happens after transactions d Adverse selection happens before a transaction and Moral hazard problem happens after transactions 4 What is the best explanation for why the Lemons problem exist a Asymmetric information b Transaction cost c Not enough lemonade d Stupid people 5 What is an example of market failure a Jane doesn t buy a car because she doesn t know the history of the car b James bargains with the guy about the car and finally buys it for less than it is worth c Jackie buys a car for more than it is worth d After Judy s boyfriend concludes that the car is in good shape she buys it from the owner 6 Which of the following did we see in the Enron scandal a Adverse selection problem b Moral Hazard problem c Principle agent problem d Lemons problem 7 Which of the following is not one of the 8 basic facts on financial structure a Interest rates on bonds of different maturities tend to move together over time b Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations c Indirect finance is many times more important than direct finance d Financial intermediaries in particular banks are the most important source of external funds 8 The principle agent problem would not happen if a Owners have complete information about the activities of the managers 9 Which of the following is true about adverse selection a More likely to obtain funds from banks and financial intermediaries rather than from securities market Fill in the Blank 1 Problem helps to explain why the private production and sale of information cannot eliminate 2 Is the more you produce the cheaper it cost while has multiple products of production
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