448 Economics Class Notes 11/4/09
ASSIGNMENT FOR PRESENTATIONS: You must write 1-2 pages on the question that is given to the class for each inclass presentation. There are 8 presentations, you must choose FOUR (4) of the 8 to write a response to. Do we choose the Equity or Bond market to raise venture capital? BOTH There are agency problems with equity and debts (bond) markets Two projects to choose to invest in: Project A: If I invest in this project, I am guaranteed to earn $110 by the end of the year Project B: If I invest in this project, I have a 10% chance of earning $120 and a 90% chance of earning $0 (nothing You need to make a $100 investment to invest in EITHER project So, 10% rate of return for project A 20% rate of return for project B 10% of the time o 90% of the time I am going to make a negative expected rate of return If you are an inside equity owner: Project A is really a better choice. ENTIRE VENTURE IS FUNDED THROUGH DEBT: Now, what if you get a loan of $100? The lender is promised a fixed rate of return. The interest on the loan is 10% 10% of return
Now PROJECT B is looking more attractive. There is a 10% chance of making $120, and 90% chance of making $0. If you lose, you only lose the lenders money, NOT YOURS. If you win, you earn ALL OF THE PROFITS RISK-SHIFTING INCENTIVE or ASSET-SUBSTITUTION EFFECT - Lots of debt = leverage firms have incentives to take/make risky investments o Borrow is the beneficiary of the increased risk o Lender takes on ALL OF THE RISK o Risk is shifted AWAY from the BORROWER and to the LENDER o Borrowers take on HUGE amounts of debt When and if the borrowers CANT pay back the principal + interest, it is the LENDER that gets screwed, NOT the borrower so borrowers have a lot of incentive to take on risky investments (SEE THE GRAPH) Comparing two different types of industries: Utility companies: take on lots of debt o Debt-equity ratio is much HIGHER Computer software companies: take on FAR LESS DEBT o Debt-equity ratio is much LOWER If you think about the types of investments that utility companies can do, they are VERY LIMITED in the kinds of activities The utility companies are not able to borrow a bunch of money and go do something crazy there is LOW VARIANCE in the kinds of investments made they The possibilities for the computer software companies investments are much GREATER --. GREATER VARIANCE in the types of investments that can be made MUCH LOWER DEBT, MORE EQUITY. IF there are limitations on the variance in the types of investments the companies can make, then we see that the companies in those industries take on A LOT MORE DEBT compared to other industries that have HIGHER variance in the kinds of investments they can make The cost of debt is a determinant factor in determining the kinds of financing used
PAUL DAVID Clio and the Economics of QWERTY PATH DEPENDENCE PATH DEPENDENCE we get locked into a certain way of doing things. Even if there is a better technology available, theory of path dependence says that we wont change to the new technology. History matters Randomness matters Path dependence a path dependent sequence of economic changes is one of which important influences upon the eventual outcome can be exerted by temporally We live with the ramifications of past events Companies that are OVER-LEVERAGED will tend to take on TOO MUCH RISK. But NOT all companies do this. * Utility companies are over-leveraged, but dont take on too much risk. NON-ERGODIC Websters definition of ergodic: involving or relating to the probability that any state will recur, especially having zero probability that any state will never recur. o Its an experiment that I can repeat o Its a repeatable world in which I can do experiments over and over and over. o Doing the same things over and over Non-ergodic processes are non-repeating. The underlying structural forces are changing (evolving) and therefore do not create repeatable experiments. History matters. o These processes dont occur again. o Everything is changing, so its really hard to come up with a baseline from which everything deviates Robert Solow There is a single universally valid model of the world. It only needs to be applied. o This is NOT TRUE. We get locked into certain technologies (path dependency). This is why some people tend to not switch to new, better technology.
We get locked into certain types of (governmental) institutions (path dependency). ASSIGNMENTS: Read PAUL DAVIDS QWERTY article and the LEBOWITZ article (the response to Paul Davids QWERTY article).