lec 4 - Econ 138 Financial and Behavioral Economics Lecture...

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Econ 138 Financial and Behavioral Economics Lecture 4: Moral Hazard ( continued ) Ulrike Malmendier UC Berkeley Th, January 31, 2008
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Organizational Items Chairs Reminder: Problem Set 1 due next class (Tu, 2/5) Updated syllabus ( show )
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1 Moral Hazard (A reminder of set-up from last class:) Firm has a (known, non-random) investment return function R ( I ) , where I is the cost of the investment and R is de fi ned on [0 , ) , R 0 > 0 , R 00 < 0 .; existing assets A ; and s shares of stock outstanding. R is ‘common knowledge.’ (CEO and investors know R .) Two fi nancing options. Using cash fl ow C , which is fl owing in from previous projects. Issuing s 0 shares of stock. (We ignore debt fi nancing for now to keep things simple.) Interest rate normalized to 0 . Competitive market for external fi nancing: outside investors demand zero returns.
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Timeline : t = 0 t = 2 t = 1 Assets A Manager and investors learn return function Cash flow C realized Manager chooses I Manager issues s shares Return R( I ) realized
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How should the manager invest from current shareholders’ perspective? max I s s + s 0 ( A + R ( I )) s.t. s 0 s + s 0 · ( A + R ( I )) = I C if I > C Why? = To gain intuition, we distinguished 2 cases: 1. CEO has su cient internal funds ( C ) to fi nance all desired investment projects. = Budget constraint not binding. = Maximizes A + C + R ( I ) I. = Invests at the fi rst best level, where R 0 ( I ) = 1 . This condition de fi nes a unique, interior solution for the optimal level of investment I as long as R 0 ( I ) > 1 for some I.
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2. CEO cannot fi nance all desired investment internally. = CEO must fi nance (at least) I C by issuing new equity. ( s 0 number of shares) = Assume, w.l.o.g., that the CEO fi rst expends the full amount of internal funds and raises the remaining fi nancing for investment by is- suing new equity. = Budget constraint: s 0 s + s 0 ( A + R ( I )) = I C . (Why?) = CEO maximizes shareholder value subject to the fi nancing con- straint: max I s s + s 0 ( A + R ( I )) s.t. s 0 s + s 0 · ( A + R ( I )) = I C = First-order condition?
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