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 f 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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1D e b t O v e r h a n g ( r e c a p ) Debt Overhang = Situation in which a pro f table project (which would always be f nanced in the absence of previous claims) is not been f 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 f nanced by new investors without debt ( D =0 ) but not with debt ( D> 0 )i f 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 f 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 f nance it since the expected net payo f from f nancing ( p H ( R R m ) I = C> 0 ) is higher than the payo f for them if it is not f 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 f nance it if old investors ‘forgive’ enough debt so that it is pro f table for new investors. If old investors forgive at least D = D D ,de f ned by p H ( R D B p )= I. Expected payo f old investors: p H D = p H ( R B p ) I = C> 0 instead of 0 . Expected payo f new investors: p H ( R D B p ) I =0 ‘instead of 0 .’ (Underlying assumption: competitive market for external f nancing.) Expected payo f manager/entrepreneur: p H B p instead of 0 . = Renegotiation bene f ts all sides.
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2 Investment-Cash Flow Sensitivity Empirical fact : Internal funds (retained earnings) are a dominant source of f 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. Ourea r l iercomments : MH interpretation of overinvestment: whenever the manager has lots of cash, he invests in his pet projects and waste shareholders’ money. (We
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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 ) . Suppose our universe of
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This note was uploaded on 04/02/2008 for the course ECON 138 taught by Professor Malmendier during the Spring '08 term at University of California, Berkeley.

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lec8 _with_some_answers - Econ 138 Financial and Behavioral...

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