lec7 - Econ 138 Financial and Behavioral Economics Lecture...

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Econ 138 Financial and Behavioral Economics Lecture 7: Financing Constraints and Debt Overhang Ulrike Malmendier UC Berkeley Tu, February 12, 2008
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Admin / Organization Problem Set 1 Breakdown of points/students 2 1 4 1 8 1 9 1 10 1 11 1 18 2 19 2 20 1 21 3 22 4 24 27 ( Mean: 20 . 85 points)
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Note : Seven people did not hand in the PS. Evaluated as 0 points. (Some of them may have dropped the class now.) Note (2) : This was meant to be an easy PS to ‘warm you up.’ If you have less than 12 points, this class is likely to become very, very di cult for you. If you have less than the mean, you need to work harder, too. Problem Set 2 Should be a good preparation for the fi rst midterm (together with PS 1). Let’s go over it. NEW wrds login and pwd (old will expire in March) login: econ234 pwd: Econ234C Due: next Tuesday, 2/19, in class.
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1 Debt Overhang (continued) Debt Overhang = Situation in which a pro fi table project (which would always be fi nanced in the absence of previous claims) is not been fi nanced due to ‘overhanging debt’ (previous claims). Can the model of credit-rationing explain this phenomenon? Version 1 (simple extension of the credit-rationing model) Firm has positive cash, C > 0 . Firm owes D to prior investors (from previous borrowing). Cash C is pledged to prior investors in case of default, and fi rm cannot raise more funds without their consent.
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Under what conditions would the project be fi nanced if the fi rm did not have previous debt? Answer : C C = I p H ( R B p H p L ) Under what conditions will the project not be fi nanced given that the fi rm does have previous debt? Answer : C D < C = I p H ( R B p H p L ) Intuition: Investors as a whole (prior + new) cannot recoup the cost of their investment ( I C ) plus previous debt D .
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