Lecture12 - 13 - agency moral hazard adverse selection

Canalsothinkofusingdebttosignaltocompetingfirms

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: better off by holding only a small fraction of the firm’s shares The entrepreneur knows the true expected return of the project, but outside investors do not. Outside investors will price each project according to their perception of the average expected profitability But then, the average expected returns of projects offered will be low, as only low return projects are offered Some good projects not financed due to adverse selection 30 Signaling with Retained Ownership in IPOs However, the α% of shares retained by the entrepreneur is a credible signal to communicate his private information All projects have similar risk, but some have high expected returns and others have low expected returns Holding 10% of shares is more costly for an entrepreneur with a low expected return project than for one with a high expected return project, as risk is similar Entrepreneurs with high ER projects will retain a large fraction of the firm’s equity, and those with low ER projects will retain a low fraction. 31 Signaling with Retained Ownership in IPOs Equilibrium market valuation: If the entrepreneur retains high ownership in the firm, the market will infer that the project has high ER If the entrepreneur retains low ownership in the firm, the market will infer that the project has low...
View Full Document

Ask a homework question - tutors are online