lec8 _with_some_answers - Econ 138 Financial and Behavioral...

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Econ 138 Financial and Behavioral Economics Lecture 8: Debt Overhang, I/CF sensitivity, and Diversi fi cation Ulrike Malmendier UC Berkeley Th, February 14, 2008
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Organization Next Tu: PS2 due. Next Th: midterm.
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1 Debt Overhang (recap) 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). Version 1 (simple extension of the credit-rationing model) Firm owes D to prior investors (from previous borrowing). Project would be fi nanced by new investors without debt ( D = 0 ) but not with debt ( D > 0 ) if C C > C D , with C = I p H ( R B p H p L ) .
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Version 2 (Lack of Renegotiation) Special case of a project that would be fi nanced by new investors without debt but not with debt: no cash ( C = 0 ) but “ slack ” in pledgable income ( C > 0 ), hence 0 > C > D or even 0 > C > p H D. However, old investors are willing to fi nance it since the expected net payo ff from fi nancing ( p H ( R R m ) I = C > 0 ) is higher than the payo ff for them if it is not fi nanced ( 0 ). Insight: If there is ‘slack’ in the pledgable income, C < 0 , and old investors have additional funds, then the investment will happen.
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Alternatively, new investors are willing to fi nance it if old investors ‘forgive’ enough debt so that it is pro fi table for new investors. If old investors forgive at least D = D D , de fi ned by p H ( R D B p ) = I. Expected payo ff old investors: p H D = p H ( R B p ) I = C > 0 instead of 0 . Expected payo ff new investors: p H ( R D B p ) I = 0 ‘instead of 0 .’ (Underlying assumption: competitive market for external fi nancing.) Expected payo ff manager/entrepreneur: p H B p instead of 0 . = Renegotiation bene fi ts all sides.
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2 Investment-Cash Flow Sensitivity Empirical fact : Internal funds (retained earnings) are a dominant source of fi nancing in all countries. Two interpretations: When managers have little cash (internal funds), they underinvest. When managers have lots of cash (internal funds), they over-invest. Our earlier comments: MH interpretation of overinvestment: whenever the manager has lots of cash, he invests in his pet projects and waste shareholders’ money. (We sketched a model of this ‘Free Cash Flow Problem’ when introducing Moral Hazard.) Is there a MH interpretation of underinvestment?
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For simplicity, consider D = 0 . (No change if you add it back; just more notation to carry around.) Let’s introduce a variable name for pledgeable income: ρ p H ( R B p ) .
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