Lecture Note Five_Tsing Hua_2009 - Corporate Finance...

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Unformatted text preview: Corporate Finance Lecture Note 5 1 Lecture Note 5 Valuation under Asymmetric Information and Agency Costs Corporate Finance Lecture Note 5 2 What is in This Note? • Valuation under Asymmetric Information – What are the mechanisms to reduce the adverse impact of asymmetric information • Valuation under Agency costs – What are the mechanisms to reduce the agency costs Corporate Finance Lecture Note 5 3 Roadmap • Overview of Asymmetric Information • Overview of the Adverse Impact of Asymmetric Information • Overview of Using Debt as a Mechanism to reduce the adverse impact of Asymmetric Information Corporate Finance Lecture Note 5 4 Valuation under Asymmetric Information: managers know something that you do not know Corporate Finance Lecture Note 5 5 Valuation under Asymmetric Information • Thus far, we have considered taxes, and financial distress costs • In this Lecture Note, we will first introduce asymmetric information • It is a general feature of corporations that managers know more than outside investors Corporate Finance Lecture Note 5 6 Asymmetric information between managers and investors • If managers know more about firm prospects than investors, it may be difficult for them to procure financing for their firms Corporate Finance Lecture Note 5 7 Asymmetric information between managers and investors • Consider a Biotech firm which is owned by its management. Approval for its drug Emem is pending from FDA (Food and Drug Administration). • In the meantime, it has to raise finance via a share issue to set up the marketing network and commercial production facilities for Emem. Corporate Finance Lecture Note 5 8 • Because of competitive pressure, if it waits until the FDA approves to invest, it will no longer be worthwhile to manufacture the drug. • Approval will increase its ability to sell the other products it manufactures (i.e., growth opportunities). Thus, the NPV of manufacturing Emem and the PV of Non Emem related assets depend on the FDA decision. o Approval Non-Approval Probability 0.5 0.5 Value of non-Emem Assets 150 50 NPV of Emem (investment=100) 20 10 Corporate Finance Lecture Note 5 9 Management learns from the FDA’s Behavior whether it will approve the drug or not. It has to issue shares to finance the investment. The investment is undertaken after the share issue. FDA announces Its decisions Date 1 Date 0 Date -1 Will the management issue equity and undertake the project? Assume the discount rate is zero. Corporate Finance Lecture Note 5 10 • We look for an equilibrium. • We proceed by making conjectures about the actions (issue equity/not issue equity) management will take given its information and then calculate market prices....
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Lecture Note Five_Tsing Hua_2009 - Corporate Finance...

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