Chapter 8 - An Economic Analysis of Financial Structures

What is a financial structure?

How a business finances itself using external funds obtained from sources outside the business.

what are the two components of financial structure?

Mix: The proportion of external financing obtained through debt versus equity.

Source: The proportion obtained through financial intermediaries versus securities markets.

what are transactional costs?

The costs associated with completing a financial transaction, such as brokerage commissions and legal fees.

what are informational costs?

Costs incurred by savers and lenders when evaluating borrowers' creditworthiness and monitoring how borrowed funds are used.

what is asymmetric information?

A situation in which one party involved in a transaction has insufficient knowledge about the other party, creating an information imbalance.

what is collateral?

An asset pledged by a borrower to secure a loan. If the borrower defaults, the lender can seize the asset to recover the outstanding debt.

what is net worth?

The difference between an individual's or a firm's total assets and total liabilities.

Assets - Liabilities

what are restrictive covenants?

Provisions included in debt contracts that restrict or require certain borrower activities to protect the lender and reduce moral hazard.

what are the eight basic facts about financial structure?

- Stocks are not the most important source of external financing.

- Marketable securities (stocks and bonds) are not the primary source of external financing.

- Indirect finance through financial intermediaries is much more important than direct finance.

- Banks are the most important source of external funds.

- The financial system is one of the most heavily regulated sectors.

- Only large, well-established firms have easy access to securities markets.

- Collateral is prevalent in debt contracts.

- Debt contracts are complicated and contain numerous restrictive covenants.

why are stocks not the most important source of external financing?

Businesses rely much more heavily on debt financing than equity financing. According to the lecture guide, approximately 89% of external financing comes from debt and 11% from equity.

why are marketable securities not the primary source of external financing?

Businesses obtain most of their external financing through sources other than publicly traded stocks and bonds. In Canada, marketable securities account for approximately 27% of external financing (15% bonds and 12% stocks).

why is indirect finance more important than direct finance?

Financial intermediaries, such as banks, play a larger role in directing funds from savers to borrowers. Even securities markets overstate direct financing because financial intermediaries purchase many newly issued securities rather than individual households.

why are banks the most important source of external financing?

Banks specialize in reducing transaction costs, gathering information about borrowers, evaluating creditworthiness, and monitoring how borrowed funds are used.

why is the financial system heavily regulated?

Government regulation helps:

- Promote the availability of reliable financial information.

- Protect consumers and investors.

- Ensure financial stability.

- Reduce fraudulent activities.

why do only large, well-established firms have easy access to securities markets?

Large firms have more publicly available information, making it easier for investors to evaluate their financial condition and creditworthiness. This reduces adverse selection.

Why is collateral commonly used in debt contracts?

Collateral provides lenders with an asset they can seize if borrowers default. It reduces the lender's potential losses and discourages borrowers from engaging in risky behaviour.

Why are debt contracts complicated and contain restrictive covenants?

Restrictive covenants limit borrowers' ability to engage in activities that could prevent repayment. They help protect lenders against moral hazard.

How do financial intermediaries reduce transaction costs?

Economies of scale: Pooling funds from numerous investors spreads transaction costs across many investments.

Expertise: Developing specialized skills and knowledge allows intermediaries to complete financial transactions more efficiently.

What are economies of scale in financial intermediation?

The reduction in transaction costs per dollar invested as the size of transactions increases. Pooling investors' funds allows intermediaries to spread fixed costs across many transactions.

How does expertise help financial intermediaries reduce transaction costs?

Intermediaries develop specialized knowledge and skills that allow them to perform financial activities more efficiently and at a lower cost.

What are liquidity services?

Services provided by financial intermediaries that make financial transactions easier and more convenient for investors.

Example: Money market mutual funds provide relatively high interest while allowing investors to write cheques.

What are the two types of asymmetric information?

Adverse selection: Occurs before a financial transaction.

Moral hazard: Occurs after a financial transaction.

What is adverse selection?

An information problem that occurs before a transaction when lenders cannot distinguish between low-risk and high-risk borrowers. Borrowers generally know more about their own financial condition and future performance than lenders do.

How does adverse selection create problems for lenders?

Lenders cannot accurately distinguish between good and bad borrowers, creating uncertainty about who will repay their loans.

This can result in lenders avoiding certain borrowers or refusing to lend altogether.

How does the interest rate create an adverse selection problem for banks?

Banks face two possible problems:

- Interest rate too high: Good borrowers may seek financing elsewhere, leaving the bank with riskier borrowers.

- Interest rate too low: Losses from bad borrowers may exceed profits earned from good borrowers.

Consequently, banks may decide not to lend to small businesses at all, creating potential market failure.

Why do large firms experience less adverse selection?

Large, established firms have more publicly available financial information, allowing lenders to evaluate their creditworthiness more accurately.

What is moral hazard?

An information problem that occurs after a transaction when one party engages in behaviour that is contrary to the interests of the other party.

It arises when monitoring the other party's activities is difficult or costly.

What are the four tools used to reduce adverse selection?

- Private production and sale of information.

- Government regulation.

- Financial intermediation.

- Collateral and net worth.

How does the private production and sale of information reduce adverse selection?

Private companies collect, analyze, and sell financial information about firms, allowing investors and lenders to evaluate borrowers more accurately.

Examples include Standard & Poor's and Dominion Bond Rating Service.

What is the free-rider problem in the private production of information?

Individuals who do not pay for financial information can still benefit from information purchased by others.

This reduces the incentive to produce information because companies cannot fully capture the benefits of their research.

As a result, too little information is produced.

How does government regulation reduce adverse selection?

Government regulation requires:

- Independent financial audits.

- Standardized accounting principles.

- Disclosure of sales, assets, and earnings.

These requirements improve the availability and reliability of financial information.

How does financial intermediation reduce adverse selection?

Banks specialize in collecting private information about borrowers and assessing their likelihood of default.

Through relationship banking, banks develop knowledge about individual borrowers that may not be publicly available.

How do collateral and net worth reduce adverse selection?

Collateral provides lenders with an asset to recover losses if borrowers default. Higher net worth indicates that borrowers have more assets and therefore more to lose.

These factors help lenders distinguish between borrowers and reduce potential losses.

What is the principal-agent problem?

A moral hazard problem that occurs when ownership and control of a firm are separated.

Shareholders (principals) own the company, while managers (agents) control its daily operations. Managers may pursue their own interests rather than maximizing shareholder wealth.

What are the four tools used to reduce moral hazard in equity contracts?

- Monitoring (costly state verification).

- Government regulation.

- Financial intermediation.

- Debt contracts.

How does monitoring reduce moral hazard in equity contracts?

Shareholders monitor managers' activities and financial performance to ensure that managers act in shareholders' interests.

However, monitoring is expensive and creates a free-rider problem because shareholders can benefit from monitoring performed by others without paying for it.

How does government regulation reduce moral hazard in equity contracts?

Government regulation establishes standardized accounting rules that make it easier to verify company profits and financial performance.

It also imposes strict criminal penalties for fraudulent activities.

How does financial intermediation reduce moral hazard in equity contracts?

Financial intermediaries can monitor borrowers and firms more effectively because they have specialized knowledge and financial incentives to oversee their investments.

Examples include:

- Banks monitoring borrowers.

- German banks purchasing company stock and placing employees on corporate boards.

- Venture capital firms acquiring large ownership stakes and placing representatives on company boards or in management.

What is venture capital, and how does it reduce moral hazard?

involves firms investing in startups in exchange for substantial ownership stakes.

Venture capitalists may place their own representatives on company boards or in management to monitor operations and protect their investments.

Because startups are often privately held, venture capitalists avoid the free-rider problem associated with publicly available monitoring information.

Why does venture capital play an important role in financing startups?

Federal regulations prevent banks from purchasing stock in nonfinancial firms. Venture capital firms therefore fill an important financing and monitoring role by investing directly in startups.

Why is debt financing more common than equity financing?

Debt contracts require borrowers to make fixed payments at predetermined intervals.

If borrowers make their payments, lenders do not need to know the firm's exact profits.

Lenders only need to verify the firm's financial condition if it defaults. This reduces monitoring costs (costly state verification), making debt financing more attractive than equity financing.

Why is monitoring less expensive under debt contracts than under equity contracts?

Under debt contracts, lenders only need to verify the borrower's financial performance when default occurs.

Under equity contracts, shareholders have an ongoing interest in the firm's profits and therefore need to monitor managers more frequently.

What moral hazard problem exists in debt contracts?

Borrowers may have an incentive to undertake riskier projects than lenders would prefer.

Riskier investments increase the possibility that borrowers will be unable to repay their loans.

How do net worth and collateral reduce moral hazard in debt contracts?

Net worth and collateral make debt contracts more incentive-compatible by aligning borrowers' interests with lenders' interests.

- Higher net worth means borrowers have more to lose, reducing incentives to take excessive risks.

- Lower net worth increases moral hazard and makes borrowing more difficult.

- Collateral gives borrowers an additional incentive to repay because they risk losing their pledged assets.

What are restrictive covenants, and why are they used in debt contracts?

Restrictive covenants are contractual requirements and limitations designed to prevent borrowers from engaging in activities that could threaten loan repayment.

They reduce moral hazard by controlling borrower behaviour.

What are the four types of restrictive covenants?

- Discourage undesirable behaviour: Restrict activities that could increase risk.

- Encourage desirable behaviour: Require borrowers to follow responsible financial practices.

- Keep collateral valuable: Ensure pledged assets maintain their value.

- Provide information: Require borrowers to disclose financial information.

What are the limitations of restrictive covenants?

- It is nearly impossible to prohibit every potentially risky activity.

- Borrowers may find loopholes in contractual restrictions.

- Covenants require ongoing monitoring and enforcement, which are costly.

- Monitoring creates a free-rider problem in bond markets.

Banks avoid much of the free-rider problem because private loans are not traded publicly.

What is financial repression, and how does it affect economic growth?

Financial repression refers to an underdeveloped financial system that limits the efficient allocation of financial resources.

It can slow economic growth because:

- Poor property rights prevent collateral from being used effectively.

- Weak legal systems make restrictive covenants difficult to enforce.

- Weak accounting standards reduce the availability of reliable financial information.

- Government intervention, including directed credit and state-owned banks, reduces incentives to allocate funds to their most productive uses.

What is venture capital, and what happened during the dot-com boom and bust?

Venture capital provides funding to startups in exchange for ownership stakes.

During the dot-com boom:

- VC investment increased from $5.6 billion in 1995 to over $103 billion in 2000.

- Venture capital supported companies such as Apple, Cisco, Genentech, Microsoft, Netscape, and Sun.

Large losses followed because:

- Too much money chased too few good investment opportunities, resulting in weak firms receiving funding.

- The increase in investment reduced the quality of monitoring.

- Investors became overly enthusiastic about dot-com companies without strong business plans.