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The Economic Analysis of Financial Structure

The Economic Analysis of Financial Structure. Chapter 8. Chapter 8 Learning Objectives. Describe how firms obtain financing Explain why bond financing is predominant in external financing Describe the role of financial intermediaries in external finance

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The Economic Analysis of Financial Structure

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  1. The Economic Analysis of Financial Structure Chapter 8

  2. Chapter 8 Learning Objectives • Describe how firms obtain financing • Explain why bond financing is predominant in external financing • Describe the role of financial intermediaries in external finance • Define asymmetric information, principal-agent problem, adverse selection, moral hazard, and relate to external financing • Explain why the financial system is heavily regulated

  3. Sources of financing • Internal • Trade credit • External

  4. External financing • Financial intermediaries (indirect finance)more important thanfinancial markets (direct finance).

  5. Questions • Why is indirect finance more prevalent than direct? • Why are loan contract so complex, and involve the use of collateral? • Why are only the largest companies able to issue securities? • Why are financial systems one of the most heavily regulated financial sectors?

  6. Financial intermediaries reduce transactions costs through … economies of scale expertise

  7. Peer to Peer Banking

  8. Asymmetric Information

  9. Asymmetric Information • Before the transaction … adverse selection. • After the transaction … moral hazard (also known as the principal agent problem.)

  10. Adverse Selection: The Lemons Problem • Two types of used cars: one half are high quality worth $5 thousand, one half are lemons worth $1 thousand • The average value is $3 thousand • But adverse selection says that the lemons are more likely to find their way on to the market • The market value falls below $3 thousand. • Owners of non-lemons are less likely to sell.

  11. Lemons in finance • Financial contracts that will not pay the expected cash flows.

  12. Tools to help solve adverse selection problem … • Private production and sale of information • Government regulation to increase information • Financial intermediation • Collateral and net worth

  13. Moral hazard/Principal Agent Problem The danger that an agent will change his or her behavior once a contract has been signed.

  14. Moral hazard in equity contracts • Solutions: • Monitoring activities (costly state verification) • Government regulation (accounting standards) • Financial intermediation (venture capital firms)

  15. Moral hazard in debt contracts • Solutions • Net worth and collateral • Restrictive covenants • Financial intermediation

  16. Other examples of Principal Agent Problem • Spinning (with an IPO) • Proprietary trading by an I-bank • Start-ups with venture capital

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