Lecture12 - 13 - agency moral hazard adverse selection

Evidence

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Unformatted text preview: ER Non­mimicking conditions: Entrepreneurs with low ER projects do not mimic those with high ER projects, that is, they do not choose to retain high ownership because it is too costly Then, there is a signaling equilibrium in which retained ownership signal project quality. IPOs where insiders retain a higher fraction of their company are sold at higher prices Empirical evidence supports this prediction 32 Signaling With Debt Debt can be used a signal of the stock's future performance Firms with high future CFs have a low cost of issuing debt (tax benefits of debt & low costs of financial distress) Firms with low future CFs have a high cost of issuing debt Thus, companies with good growth prospects can issue debt but those with poor prospects cannot Low future CF firms will not mimic high future CF firms by choosing high debt: risk of bankruptcy would be too high! Hence, a higher debt ratio may be a favorable signal that managers expect high future profits Thus, firms with higher leverage will have higher values Manag...
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