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Limitation in just changing one variable at a time.
Scenario Analysis- Change several variables together.
Break - even analysis examines variability in forecasts.
It determines the number of sales required to break even.
9
Real Options.
A digression: Financial Options
A call option gives the holder the right (but not the obligation) to buy shares at some time in the future at an exercise price agreed now.
A put option gives the holder the right (but not the obligation) to sell shares at some time in the future at an exercise price agreed now.
European Option – Exercised only at maturity date.
American Option – Can be exercised at any time up to maturity.
For simplicity, we focus on European Options.
10
Example:
• Today, you buy a call option on Marks and Spencer’s shares. The call option gives you the right (but not the obligation) to buy MS shares at exercise date (say 31/12/10) at an exercise price given now (say £10).
• At 31/12/10: MS share price becomes £12. Buy at £10: immediately sell at £12: profit £2.
• Or: MS shares become £8 at 31/12/10: rip option up!
11
Factors Affecting Price of European Option (=c).
-Underlying Stock Price S.
-Exercise Price X.
-Variance of of the returns of the underlying asset ,
-Time to maturity, T.
.0,0,0,02
T
cc
X
c
S
c
2
The riskier the underlying returns, the greater the probability that the stock price will exceed the exercise price.
The longer to maturity, the greater the probability that the stock price will exceed the exercise price.
12
Options: Payoff Profiles.
Buying a Call Option.
S
WSelling a put option.
Selling a Call Option. Buying a Put Option.
13
Pricing Call Options – Binomial Approach.
S=20
q
1- q dS=13.40
uS=24.00
S = £20. q=0.5. u=1.2. d=.67. X = £21.
1 + rf = 1.1.
Risk free hedge Portfolio: Buy One Share of Stock and write m call options.
uS - mCu = dS – mCd => 24 – 3m = 13.40.
M = 3.53.
By holding one share of stock, and selling 3.53 call options, your payoffs are the same in both states of nature (13.40): Risk free.
cq
1- q
Cu = 3
Cd=0
14
Since hedge portfolio is riskless:
.))(1( uf mcuSmcSr
1.1 ( 20 – 3.53C) = 13.40.
Therefore, C = 2.21.
This is the current price per call option. The total present value of investment = £12 .19, and the rate of return on investment is
13.40 / 12.19 = 1.1.
15
Alternative option-pricing method
• Black-Scholes
• Continuous Distribution of share returns (not binomial)
• Continuous time (rather than discrete time).
16
Real Options
• Just as financial options give the investor the right (but not obligation) to future share investment (flexibility)
• Researchers recognised that investing in projects can be considered as ‘options’ (flexibility).
• “Real Options”: Option to delay, option to expand, option to abandon.
• Real options: dynamic approach (in contrast to static NPV).
17
Real Options
• Based on the insights, methods and valuation of financial options which give you the right to invest in shares at a later date
• RO: development of NPV to recognise corporation’s flexibility in investing in PROJECTS.
18
Real Options.
• Real Options recognise flexibility in investment appraisal decision.
• Standard NPV: static; “now or never”.
• Real Option Approach: “Now or Later”.
• -Option to delay, option to expand, option to abandon.
• Analogy with financial options.
19
Types of Real Option
• Option to Delay (Timing Option).
• Option to Expand (eg R and D).
• Option to Abandon.
20
Option to Delay (= call option)
•
Project value
Value-creation
Investment in waiting:
(sunk)
21
Option to expand (= call option)
•
Project value
Value creation
Investment in initial project: eg R and D (sunk)
22
Option to Abandon ( = put option)
•
Project value
Project goes badly: abandon for liquidation value.
23
Valuation of Real Options
• Binomial Pricing Model
• Black-Scholes formula
24
Value of a Real Option
• A Project’s Value-added = Standard NPV plus the Real Option Value.
• For given cashflows, standard NPV decreases with risk (why?).
• But Real Option Value increases with risk.
• R and D very risky: => Real Option element may be high.
25
•
Simplified Examples
• Option to Expand (page 241 of RWJ)
Build First Ice
Hotel
If Successful
Expand
If unsuccessful
Do not Expand
26
• NPV of single ice hotel
• NPV = - 12,000,000 + 2,000,000/0.20 =-2m
• Reject?
• Optimistic forecast: NPV = - 12M + 3M/0.2
• = 3M.
• Pessimistic: NPV = -12M + 1M/0.2 = - 7m
• Still reject?
Option to Expand (Continued)
27
Option to expand (continued)
• Given success, the E will expand to 10 hotels
• =>
• NPV = 50% x 10 x 3m + 50% x (-7m) = 11.5 m.
• Therefore, invest.
28
Option to abandon.
• NPV(opt) = - 12m + 6m/0.2 = 18m.
• NPV (pess) = -12m – 2m/0.2 = -22m.
• => NPV = - 2m. Reject?
• But abandon if failure =>
• NPV = 50% x 18m + 50% x -12m/1.20
• = 2.17m
• Accept.
29
Option to delay and Competition (Smit and Ankum).
•-Smit and Ankum present a binomial real option model:
•Option to delay increases value (wait to observe market demand)
• Application to Qinetiq (article by Tony Bishop).
33
Use of Real Options in Practice
•
34
Lecture 5 and 6: Capital Structure and Dividends.
Positive NPV project immediately increases current equity value (share price immediately goes up!)
oo EBV Pre-project announcement
New project: .IVNPV n INew capital (all equity)
I
Value of Debt oBIVE n 0
New Firm Value
Original equity holders
New equity
nVV
35
Example:
oo EBV =500+500=1000.
I
IVNPV n 60 -20 = 40.
oB = 500.
IVE n 0 = 500+40 = 540
I = 20
nVV =1000+60=1060.
20
Value of Debt
Original Equity
New Equity
Total Firm Value
36
Positive NPV: Effect on share price.
Assume all equity.
Market No of Price per Market No of Price per£K Value Shares Share Value Shares Share
Current 1000 1000 1 1040 1000 1.04
New Project 20 19 1.04
Project Income 60 1060 1019 1.04
Required Investment 20
NPV 40
37
Value of the Firm and Capital Structure
Value of the Firm = Value of Debt + Value of Equity = discounted value of future cashflows available to the providers of capital.
(where values refer to market values).
Capital Structure is the amount of debt and equity: It is the way a firm finances its investments.
Unlevered firm = all-equity.
Levered firm = Debt plus equity.
Miller-Modigliani said that it does not matter how you split the cake between debt and equity, the value of the firm is unchanged (Irrelevance Theorem).
38
Value of the Firm = discounted value of future cashflows available to the providers of capital.
-Assume Incomes are perpetuities.
Miller- Modigliani Theorem:
..)1(
.
)1(
d
dDEUL
EU
K
Bk
eK
NIVV
WACC
TNCFBTVV
VTNCF
V
Irrelevance Theorem: Without Tax, Firm Value is independent of the Capital Structure.
MM assumed that investment and financing decisions were separate. Firm first chooses its investment projects (NPV rule), then decides on its capital structure.
Pie Model of the Firm:
D
E
E
42
MM irrelevance theorem- firm can use any mix of debt and equity – this is unsatisfactory as a policy tool.
Searching for the Optimal Capital Structure.
-Tax benefits of debt.
-Asymmetric information- Signalling.
-Agency Costs (selfish managers).
-Debt Capacity and Risky Debt.
Optimal Capital Structure maximises firm value.
43
Combining Tax Relief and Debt Capacity (Traditional View).
D/E D/E
V
K
44
Section 4: Optimal Capital Structure, Agency Costs, and Signalling.
Agency costs - manager’s self interested actions. Signalling - related to managerial type.
Debt and Equity can affect Firm Value because:
- Debt increases managers’ share of equity.
-Debt has threat of bankruptcy if manager shirks.
- Debt can reduce free cashflow.
But- Debt - excessive risk taking.
45
AGENCY COST MODELS.
Jensen and Meckling (1976).
- self-interested manager - monetary rewards V private benefits.
- issues debt and equity.
Issuing equity => lower share of firm’s profits for manager => he takes more perks => firm value
Issuing debt => he owns more equity => he takes less perks => firm value
46
Jensen and Meckling (1976)
B
V
V*
V1
B1
A
If manager owns all of the equity, equilibrium point A.
Slope = -1
47
B
V
Jensen and Meckling (1976)
V*
V1
B1
AB
If manager owns all of the equity, equilibrium point A.
If manager owns half of the equity, he will got to point B if he can.
Slope = -1
Slope = -1/2
48
B
V
Jensen and Meckling (1976)
V*
V1
B1
AB
C
If manager owns all of the equity, equilibrium point A.
If manager owns half of the equity, he will got to point B if he can.
Final equilibrium, point C: value V2, and private benefits B1.
V2
B2
Slope = -1
Slope = -1/2
49
Jensen and Meckling - Numerical Example.PROJECT PROJECTA B
EXPECTED INCOME 500 1000
MANAGER'S SHARE:100% 500 1000
VALUE OF PRIVATE 800 500BENEFITS
TOTAL WEALTH 1300 1500
MANAGER'S SHARE:50% 250 500
VALUE OF PRIVATE 800 500BENEFITS
TOTAL WEALTH 1050 1000
Manager issues 100% Debt.
Chooses Project B.
Manager issues some Debt and Equity.
Chooses Project A.
Optimal Solution: Issue Debt?
50
Issuing debt increases the manager’s fractional ownership => Firm value rises.
-But:
Debt and risk-shifting.
State 1 100 0 0.5
State 2 100 170 0.5
100 85
Values: Debt 50 25
Equity 50 60
51
OPTIMAL CAPITAL STRUCTURE.
Trade-off: Increasing equity => excess perks.
Increasing debt => potential risk shifting.
Optimal Capital Structure => max firm value.
D/E
V
D/E*
V*
52
Other Agency Cost Reasons for Optimal Capital structure.
• Predation models: higher competition leads to lower debt. (Why?)
69
Capital Structure and Takeovers
• Garvey and Hanka:
• Waves of takeovers in US in 1980’s/1990’s.
• Increase in hostile takeovers => increase in debt as a defensive mechanism.
• Decrease in hostile takeovers => decrease in debt as a defensive mechanism.
70
Garvey and Hanka (contiuned)
•
D/E
D/E*
V Trade-off: Tax shields/effort levels/FCF/ efficiency/signalling Vs financial distress
71
Practical Capital Structure: case study
•
72
Lecture 6: Dividend Policy
• Miller-Modigliani Irrelevance.
• Gordon Growth (trade-off).
• Signalling Models.
• Agency Models.
• Gordon Growth (trade-off).
• Lintner Smoothing.
• Dividends versus share repurchases.
73
Early Approach.
• Three Schools of Thought-
• Dividends are irrelevant.
• Dividends => increase in stock prices.
• Dividends => decrease in Stock Prices.
74
A. Dividend Irrelevance.
Assume All equity firm.
Value of Firm = Value of Equity = discounted value of future cashflows available to equity holders = discounted value of dividends (if all available cashflow is paid out).
0
0
0
0
)1(
)1(
tt
t
tt
INCFV
DivV
t
t
If everything not reinvested is paid out as dividends, then
75
Miller Modigliani’s Dividend Irrelevance.
NSDivINCF
DivINSNCF
tttt
tttt
Source of Funds = Application of Funds
MM used a source and application of funds argument to show thatDividend Policy is irrelevant:
11
0)1()1( t
ttt
tt
tt INCFNSDivV
76
1
0)1(t
ttt INCF
V
-Dividends do not appear in the equation.
-If the firm pays out too much dividend, it issues new equity to be able to reinvest. If it pays out too little dividend, it can use the balance to repurchase shares.
-Hence, dividend policy irrelevant.
-Key is the availability of finance in the capital market.
77
Example of Dividend Irrelevance using Source and Application of Funds.
Firm invests in project giving it NCF = 100 every year, and it needs to re-invest, I =50 every year.
Cashflow available to shareholders = NCF – I = 50.
Now, NCF – I = Div – NS = 50.
If firm pays dividend of 50, NS = 0 (ie it pays out exactly the cashflow available – no new shares bought or sold).
If firm pays dividend of 80, NS = -30 (ie it sells new shares of 30 to cover dividend).
If firm pays dividend of 20, NS = 30 (ie it uses cashflow not paid out as dividend to buy new shares).
In each case, Div – NS = 50.
78
Dividend irrelevance (from Lease et al book chapter 2
• Appendix 2a.
79
B. Gordon Growth Model.
Where does growth come from?- retaining cashflow to re-invest.
.)1(11
0Kr
KNCFg
DivV
Constant fraction, K, of earnings retained for reinvestment.
Rest paid out as dividend.
Average rate of return on equity = r.
Growth rate in cashflows (and dividends) is g = Kr.
80
Example of Gordon Growth Model.£K 19x5 19x6 19x7 19x8 19x9 Average Profits After Tax (NCF) 2500 2760 2635 2900 3100Retained Profit (NCF.K) 1550 1775 1600 1800 1900
Retention Rate K 0.62 0.64 0.61 0.62 0.61 0.62r on opening capital 0.083 0.087 0.079 0.083 0.084 0.083
g = Kr = 0.05.
How do we use this past data for valuation?
81
Gordon Growth Model (Infinite Constant Growth Model).
Let %12
05.012.0
1260)05.1(1200)1( 100
gg
Div
g
gDivV
= 18000
82
Finite Supernormal Growth.
-Rate of return on Investment > market required return for T years.
-After that, Rate of Return on Investment = Market required return.
)1(
)(.. 1
10
rTNCFK
NCFV
If T = 0, V = Value of assets in place (re-investment at zero NPV).
Same if r = .
83
Examples of Finite Supernormal Growth.
%.10
.1001
NCF
T = 10 years. K = 0.1.
A. Rate of return, r = 12% for 10 years,then 10% thereafter.
1018)1.01(1.0
)1.012.0(10).100.(1.0
1.0
1000
V
B. Rate of return, r = 5% for 10 years,then 10% thereafter.
955)1.01(1.0
)1.005.0(10).100.(1.0
1.0
1000
V
84
Are Dividends Irrelevant?
- Evidence: higher dividends => higher value.
- Dividend irrelevance : freely available capital for reinvestment. - If too much dividend, firm issued new shares.
- If capital not freely available, dividend policy may matter.
C. Dividend Signalling - Miller and Rock (1985).
NCF + NS = I + DIV: Source = Uses.
DIV - NS = NCF - I.
Right hand side = retained earnings. Left hand side - higher dividends can be covered by new shares.
85
Div - NS - E (Div - NS) = NCF - I - E (NCF - I)
= NCF - E ( NCF).
Unexpected dividend increase - favourable signal of NCF.
Prob 0.5 0.5
Firm A Firm B E(V)
NCF 400 1400 900
New Investment 600 600 600
Dividend 0 800 400New shares 200 0 100
E(Div - NS) = E(NCF - I) = 300.
Date 1 Realisation: Firm B: Div - NS - E (Div - NS) = 500 = NCF - E ( NCF).
Firm A : Div - NS - E (Div - NS) = -500 = NCF - E ( NCF).
86
Dividend Signalling Models.
• Bhattacharya (1979)• John and Williams (1985)• Miller and Rock (1985)• Ofer and Thakor (1987)• Fuller and Thakor (2002).• Fairchild (2009/10).• Divs credible costly signals: Taxes or borrowing
costs.
87
Dividends as signals of expected cashflows: Bhattacharya 1979.
• Asymmetric Info about cashflows.
• Investors invest over short horizons.
• Dividends taxed at higher rate than capital gains.
• => signalling equilibria.
• Shorter horizon => higher dividends.
88
Signalling, FCF, and Dividends.Fuller and Thakor (2002)
• Empirical Contest between Signalling and FCF hypotheses.
• Divs’ costly signals: signalling plus FCF.
• If dividend too low: FCF problem (cf Jensen 1986).
• If dividend too high: costly borrowing.
89
Fuller and Thakor (continued).
• 2 types of firm: good and bad.
• Good firm’s future
• Bad firm’s future
}.,{ LHCF
}.0,{LCF
qBLxGHx )/Pr()/Pr(
qBxGLx 1)/0Pr()/Pr(
90
Fuller and Thakor (continued)
• At date 1, outsiders observe signal
• If firm G,
• If firm B,
• Thus, if or mkt knows firm type. Divs used to eliminate FCF.
• If mkt cannot identify type. Thus, divs used to signal type and eliminate FCF.
},,0{ HLS
},{ HLS
},0{ LS
HS ,0S
,LS
91
Fuller and Thakor (continued)
• Firms’ dividend announcement trades-off costly borrowing versus FCF problem.
• Bayesian updating.
divmediumHS .divlowS .0
divHighgoodfirmLS .,
divlowbadfirmLS .,
92
Dividend Signalling: Current Income/future Investment:
Fairchild (2009/10).
• Conflicting signals:
• High/low dividends signal high/low income
• But high/low dividends affect ability to re-invest (cf Gordon Growth)
• If –ve NPV: FCF: High divs good.
• But if +ve NPV: high div bad => ambiguous.
93
Fairchild (2002): continued.
• 2 all-equity firms; manager• Date 0: Project investment.• Date 1: Net income, with• Revealed to the manager, but not to
investors.• Mkt becomes aware of a new project P2,
with return on equity• Manager commits to a dividend
}.,{ bgi
,iN .bg NN
.0,0
iD
94
Fairchild (2002) continued
• Date 1.5: Mgr pays announced dividend
• P2 requires investment
• Mgr cannot take new project.
• Date 2, If P2 taken, achieves net income. Mgr has private benefits
].,( gb NNI
b
.0b
95
Fairchild (2002) continued
• Mgr maximises
• Bayesian Updating.
• Adverse selection:
• Mgr can either signal current income (but no re-investment),
• or re-invest (without signaling current income).
.1 BVM
.bg NIN
g
96
Fairchild (2002) continued
• Signalling (of current income) Equilibria:
• A) Efficient re-investment: Pooling:
• B) Inefficient Non re-investment, or
• C) Efficient Non re-investment: separating:
].,0[],,0[ INDIND gbgg
].,0[],,[ bbgbg NDNND
97
Fairchild 2002 (continued)
• Case 2: Moral Hazard:• Mgr can provide credible signal of type• Effective communication (Wooldridge and Ghosh)• Now, use divs only due to FCF.• Efficient re-investment.• Inefficient re-investment.• Efficient non re-investment.
98
Fairchild 2002: Summary
• Case 1: Adverse selection: inefficiency when mgr refuses to cut dividend to take +ve NPV project.
• Case 2: Moral hazard: mgr reduces dividend to take –ve NPV project.
• But market must be inefficient, or investors irrational.
• Isagawa.
• Fairchild and Zhang.
119
Repurchases and irrational investors.
Isagawa 2002• Timing (wealth-transfer) model.• Unable to time market in efficient market
with rational investors.• Assumes irrational investors => market
does not fully react. • Incentive to time market.• Predicts long-run abnormal returns post-
announcement.
120
Repurchase Catering.
• Baker and Wurgler: dividend catering
• Fairchild and Zhang: dividend/repurchase catering, or re-investment in positive NPV project.
121
Competing Frictions Model:From Lease et al:
•
Asymmetric Information
Agency Costs
High
Payout
Low
Payout
Taxes
High Payout
Low Payout
High PayoutLow Payout
122
Dividend Cuts bad news?
• Fairchild’s 2009/10 article.• Wooldridge and Ghosh:=>• ITT/ Gould• Right way and wrong way to cut dividends.• Other cases from Fairchild’s article.• Signalling/FCF hypothesis.• FCF: agency cost: cutting div to take –ve NPV project.• New agency cost: Project foregone to pay high dividends.• Communication/reputation important!!
123
Lecture 9: Venture Capital/private equity
• Venture capitalists typically supply start-up finance for new entrepreneurs.
• VC’s objective; help to develop the venture over 5 – 7 years, take the firm to IPO, and make large capital gains on their investment.
• In contrast, private equity firms invest in later stage public companies to take them private….
124
Private Equity.
• PE firms generally buy poorly performing publically listed firms.
• Take them private• Improve them (turn them around).• Hope to float them again for large gains• Our main focus in this course is venture capital,
But will look briefly at PE later.• “Theory of private equity turnarounds” plus PE
leverage article, plus economics of PE articles.
125
C. Venture Capital Financing
• Active Value-adding Investors.
• Double-sided Moral Hazard problem.
• Asymmetric Information.
• Negotiations over Cashflows and Control Rights.
• Staged Financing
• Remarkable variation in contracts.
126
Features of VC financing.
• Bargain with mgrs over financial contract (cash flow rights and control rights)
• VC’s active investors: provide value-added services.
• Reputation (VCs are repeat players).
• Double-sided moral hazard.
• Double-sided adverse selection.
127
Kaplan and Stromberg
• Empirical analysis, related to financial contract theories.
128
Financial Contracts.
• Debt and equity.
• Extensive use of Convertibles.
• Staged Financing.
• Control rights (eg board control/voting rights).
• Exit strategies well-defined.
129
Fairchild (2004)
• Analyses effects of bargaining power, reputation, exit strategies and value-adding on financial contract and performance.
• 1 mgr and 2 types of VC.
• Success Probability depends on effort:
VCiM eeP
},1,0{iwhere => VC’s value-adding.
130
Fairchild’s (2004) Timeline
• Date 0: Bidding Game: VC’s bid to supply finance.
• Date 1: Bargaining game: VC/E bargain over financial contract (equity stakes).
• Date 2: Investment/effort level stage.• Date 3: Renegotiation stage: hold-up
problems• Date 4: Payoffs occur.
131
Bargaining stage
• Ex ante Project Value
• Payoffs:.)1( RPPRV
.2
)()(2
mM
eIRIRPS
).Pr(2
)()()1(2
IRe
IRIIRPS mVC
132
Optimal effort levels for given equity stake:
•
,*
me
.)1(
* r
eVC
133
Optimal equity proposals.
• Found by substituting optimal efforts into payoffs and maximising.
• Depends on relative bargaining power, VC’s value-adding ability, and reputation effect.
• Eg; E may take all of the equity.
• VC may take half of the equity.
134
Equity Stake
Payoffs
E
VC
0.5
135
E’s choice of VC or angel-financing
• Explain Angels.
• Complementary efforts
• Ex post hold-up/stealing threat
136
To come
• Legal effects: (Fairchild and Yiyuan)
• => Allen and Song
• => Botazzi et al
• Negative reciprocity/retaliation.
137
Ex post hold-up threat
• VC power increases with time.
• Exit threat (moral hazard).
• Weakens entrepreneur incentives.
• Contractual commitment not to exit early.
• => put options.
138
Other Papers
• Casamatta: Joint effort: VC supplies investment and value-adding effort.
• Repullo and Suarez: Joint efforts: staged financing.
• Bascha: Joint efforts: use of convertibles: increased managerial incentives.
139
Complementary efforts (Repullo and
Suarez).
• Lecture slides to follow…
140
Control Rights.
• Gebhardt.
• Lecture slides to follow
141
Asymmetric Information
• Houben.
• PCP paper.
• Tykvova (lock-in at IPO to signal quality).
142
E’s choice of financier
• VC or bank finance (Ueda, Bettignies and Brander).
• VC or Angel (Chemmanur and Chen, Fairchild).
143
Fairness Norms and Self-interest in VC/E Contracting: A Behavioral Game-theoretic
• Procedural Justice Theory: Fairness and Trust important.
• No existing behavioral Game theoretic models of VC/E contracting.
144
My Model:
• VC/E Financial Contracting, combining double-sided Moral Hazard (VC and E shirking incentives) and fairness norms.
• 2 stages: VC and E negotiate financial contract.
• Then both exert value-adding efforts.
145
How to model fairness? Fairness Norms.
• Fair VCs and Es in society.
• self-interested VCs and Es in society.
• Matching process: one E emerges with a business plan. Approaches one VC at random for finance.
• Players cannot observe each other’s type.
rr1
146
Timeline
• Date 0: VC makes ultimatum offer of equity stake to E;
• Date 1: VC and E exert value-adding effort in running the business
• Date 2 Success Probability• => income R.• Failure probability • =>income zero
1],1,0[
VCEEE eeP
P1
147
• Expected Value of Project
• Represents VCs relative ability (to E).
ReePRV VCEEE )(
]1,0[
148
Fairness Norms
• Fair VC makes fair (payoff equalising) equity offer
• Self-interested VC makes self-interested ultimatum offer
• E observes equity offer. Fair E compares equity offer to social norm. Self-interested E does not, then exerts effort.
F
FU
149
Expected Payoffs
• PRrePR UFEUE )(2
2])1)[(1(])1[( VCFUSUVC eRPrRPr
If VC is fair, by definition, FU
150
Solve by backward induction:
• If VC is fair;
• Since
• for both E types.
• =>
• =>
FU 2
EFE ePR FS PP
2)1( VCFVC ePR
151
VC is fair; continued.
• Given FU
Optimal Effort Levels:
.2
)1(*,
2*
R
eR
e EFVC
EFE
Fair VC’s equity proposal (equity norm):
)1(3
1212
242
F
152
VC is self-interested:
• From Equation (1), fair E’s optimal effort;
•
FSFU PP
.2
)]([*
Rr
e EUFUE
153
Self-interested VC’s optimal Equity proposal
• Substitute players’ optimal efforts into V= PR, and then into (1) and (2). Then, optimal equity proposal maximises VC’s indirect payoff =>
.)1(2
)1(1*
22
22
r
r FU
154
Examples;
• VC has no value-adding ability (dumb money) =>
• =>
•
• r =0 =>
• r => 1 ,
0 3
2F
.2
1U
.3
2 FU
155
Example 2
• VC has equal ability to E; =>
• r =0 =>• r => 1 ,
• We show thatas r => 1
12
1F
.0U
.2
1 FU
],1,0[ FU
156
Table 1.
157
Graph
158
Table of venture performance
159
Graph of Venture Performance.
160
Future Research.
• Dynamic Fairness Game:ex post opportunism (Utset 2002).
• Complementary Efforts.
• Trust Games.
• Experiments.
• Control Rights.
161
Private Equity
• JCF paper: slides to follow…
• PE and leverage: slides to follow….
162
Lecture 10: Introduction to Behavioural Corporate Finance.
•Standard Finance - agents are rational and self-interested.•Behavioural finance: agents irrational (Psychological Biases).•Irrational Investors – Overvaluing assets- internet bubble? Market Sentiment?•Irrational Managers- effects on investment appraisal?•Effects on capital structure?•Herding.
163
Development of Behavioral Finance I.
• Standard Research in Finance: Assumption: Agents are rational self-interested utility maximisers.
• 1955: Herbert Simon: Bounded Rationality: Humans are not computer-like infinite information processors. Heuristics.
• Economics experiments: Humans are not totally self-interested.
164
Development of Behavioral Finance II.
• Anomalies: Efficient Capital Markets.• Excessive volatility.• Excessive trading.• Over and under-reaction to news.• 1980’s: Werner DeBondt: coined the term
Behavioral Finance.• Prospect Theory: Kahnemann and Tversky
1980s.
165
Development III
• BF takes findings from psychology.
• Incorporates human biases into finance.
• Which psychological biases? Potentially infinite.
• Gervais et al (2002), Heaton: investment appraisal, OC bad => negative NPV projects.
• Zacharakis: VC OC bad: wrong firms.
182
Overconfidence and Debt
• My model: OC => higher mgr’s effort (good).
• But OC bad, leads to excessive debt (see Shefrin), higher financial distress.
• Trade-off.
183
Behavioral model of overconfidence.
Both Managers issue debt:
.ˆ,ˆ qqpp
.)ˆ1(ˆ2
ˆ bpqp
IpRpM g
.)ˆ1(ˆ2
ˆ bqqp
IqRqM b
184
Good mgr issues Debt, bad mgr issues equity.
.)ˆ1(ˆ
ˆ bpIp
pRpM g
.ˆ
ˆ Iq
qRqM b
Both mgrs issue equity.
,ˆ2
ˆ Iqp
pRpM g
.ˆ2
ˆ Iqp
qRqM b
185
Proposition 1.
a) If
b)
,)ˆ1()ˆ1()(
)(ˆbpbqI
qpq
qpq
}.{ DSS bg
,)ˆ1()(
)(ˆ)ˆ1( bpI
qpq
qpqbq
}.,{ ESDS bg
c) ,)(
)(ˆ)ˆ1()ˆ1( I
qpq
qpqbpbq
}.{ ESS bg
Overconfidence leads to more debt issuance.
186
Overconfidence and Moral Hazard
• Firm’s project: 2 possible outcomes.
• Good: income R. Bad: Income 0.
• Good state Prob:
• True:
• Overconfidence:
• True success prob:
].1,0()( eP .0.0
.eP
187
Manager’s Perceived Payoffs
.)ˆ1()(ˆˆ 2 IPDebPDRPM D
.)1(ˆˆ 2 IPReRPM E
188
Optimal effort levels
2
))((*
bDReD
2
))((*
DReE
189
Effect of Overconfidence and security on mgr’s effort
• Mgr’s effort is increasing in OC.
• Debt forces higher effort due to FD.
190
Manager’s perceived Indirect Payoffs
bIDbDRbDR
M D
2
))((
4
)()(ˆ22
IDDRDR
M E
2
))((
4
)()(ˆ22
.2
)(
4
))(2()(ˆ22
bbDbDRb
M D
191
True Firm Value
.2
))()(()( b
bRbDRbbRPV DD
.2
))((
RDR
RPV EE
192
Effect of OC on Security Choice
024
))(2()0(ˆ
222
bbDbIRb
M D
0ˆ
DM
.0)(ˆ CDM
],,0[ C
,C
Manager issues Equity.
Manager issues Debt.
193
Effect of OC on firm Values
.2
))()(()( b
bRbDRV CD
bDRRbDbbR
VD
2
)()2)(( 22
.2
)()0(
2
RDR
VE
194
Results
• For given security: firm value increasing in OC.• If• Firm value increasing for all OC: OC good.• Optimal OC: • If • Medium OC is bad. High OC is good.• Or low good, high bad.
,0)( CDV
,0)( CDV .* max
195
Results (continued).
• If
• 2 cases: Optimal OC:
•
• Or Optimal OC:
,0)( CDV
.* max
.* C
196
Effect of Overconfidence on Firm Value
-600
-400
-200
0
200
400
600
800
1000
1200
0 0.1 0.2 0.3 0.4 0.5
Overconfidence
Val
ue
Effect of Overconfidence on Firm Value
-2000
-1500
-1000
-500
0
500
1000
1500
2000
2500
1 2 3 4 5 6 7 8 9 10
Overconfidence
Val
ue
Effect of Overconfidence on Firm Value
-2000
-1500
-1000
-500
0
500
1000
1500
2000
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
OverconfidenceV
alu
e
197
Conclusion.
• Overconfidence leads to higher effort level.
• Critical OC leads to debt: FD costs.
• Debt leads to higher effort level.
• Optimal OC depends on trade-off between higher effort and expected FD costs.