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Money and Banking

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Title: Money and Banking


1
Money and Banking
Mr. Vaughan
2
Financial-Structure Puzzles
  • Eight, interrelated puzzles, about financial
    structure
  • Financial system boasts a broad array of
    marketable securities and financial
    intermediariesand heterogeneity is increasing.
  • Internal finance is more important than external
    finance for firmsnot just in U.S., but all over
    developed world.
  • Firms seeking external finance rely more heavily
    on banks than securities marketsnot just in U.S.
    but all over developed world.
  • Only large, well-established corporations can tap
    securities markets to finance operationsnot just
    in U.S. but all over developed world.
  • Not listed in Mishkin.

3
Financial-Structure Puzzles(continued)
  • Eight, interrelated puzzles, about financial
    structure
  • U.S. firms selling securities rely more heavily
    on bonds than on stocks. (Common, but not
    universal, pattern in developed world.
  • Debt contracts typically are extremely
    complicated legal documents placing substantial
    restrictions on borrowers.
  • Collateral is a common feature of debt contracts.
  • As financial markets have grown more
    sophisticated, financial intermediation has
    become more important economically.
  • Financial system is heavily regulatednot just in
    U.S., but all over developed world.
  • Not listed in your text.

4
Sources of External FinanceCross-Country
Comparisons
5
Understanding Financial StructureModigliani-Mille
r Theorem
  • Theorem In frictionless capital markets, firm
    value depends solely on cash flows from assets.
    Capital structurei.e., how assets are
    financedplays no role.
  • Corollary NPV of investment projects doesnt
    depend on financing.
  • Definition Frictionless capital market
  • Perfect Competition
  • No transactions costs
  • No information asymmetries
  • No tax/regulatory distortions

6
Understanding Financial StructureModigliani-Mille
r Theorem
  • Intuition
  • Cash flows from assets determine the size of pie.
  • Capital structuredebt/equity mixmerely slices
    pie.
  • Firm cannot make pie larger by slicing it
    differently.

Debt
Equity
7
Modigliani-Miller TheoremLogic
  • Consider two firms with identical cash flows from
    assets
  • One has debt (levered firm) in capital structure
    other (un-levered firm) does not.
  • Investors can borrow privately on same terms as
    levered firm.
  • Total value of firm is defined as market value of
    debt plus the market value of equity. So
  • Total value of un-levered firm total value of
    outstanding shares
  • Total value of levered firm total value of
    outstanding debt total value of outstanding
    shares.

8
Modigliani-Miller TheoremLogic
  • Levered Firm
  • Cash Flows from Assets
  • - Firms Debt Service
  • Dividends Net Cash Flows

Un-levered Firm Cash Flows from Assets
Dividends - Private Debt Service Net Cash Flows
  • Net cash flows are identical.
  • Investors care only about net cash flows.
  • Arbitrage guarantees total value of levered firm
    will equal total value of un-levered firm.

9
Explanations for Financial-Structure Puzzles
  • MM identifies frictions that make financing
    choices important
  • Transactions costs
  • Asymmetric information costs
  • Taxation and Regulation
  • Financing arrangements reflect efforts to
    minimize transactions costs, information costs,
    tax burden, and regulatory burden.

10
Transactions Costs
  • Definition Time/money spent channeling funds
    from surplus units to deficit units.
  • Forms
  • Search costs
  • Negotiation costs
  • Enforcement costs
  • Implication Small firms and large firms needing
    small amounts of financing will rely on internal
    finance or bank finance.

11
Transactions Costs
  • Another Form Bankruptcy costs
  • Definition Loss of firm value arising from
    financial distress
  • Explicit bankruptcy costs lawyers and
    accountants fees, etc.
  • Implicit bankruptcy costs loss of sales, loss of
    trade credit, key employees, etc.
  • Implication Firms with intangible assets and
    attractive growth opportunities will shy away
    from debt financing.

12
Asymmetric-Information Costs
  • Definition Costs of overcoming two types of
    information problems
  • Adverse selection separating good from bad risks
    before execution of financial contract.
  • Moral hazard insuring economic agents with
    delegated authority live up to contract terms.

13
Asymmetric-Information Costs Adverse Selection
  • Example Lemons Problems
  • If investors can't distinguish good and bad
    securities, they will offer only average value.
  • Good securities will be undervalued, so firms
    won't issue them bad securities will be
    overvalued, so too many will be issued.
  • Investors do not want bad securities, so market
    falls apart.

14
Asymmetric-Information Costs Adverse Selection
  • Solutions to Lemons Problems
  • Information production by disinterested third
    party
  • Limited by free-rider problem
  • Signaling
  • collateral
  • net worth
  • reputation (a form of collateral)
  • Government regulation
  • Financial intermediation

15
Financial Frictions in Action Pecking Order
Theory of Financing
  • Adverse selection make some financing vehicles
    much more expensive than others.
  • Example
  • Managers want to issue new stock only when it is
    overvalued.
  • Stock issuance is bad signal.
  • Stock issuance causes price of outstanding stock
    to fall.
  • Decline in stock price is part of cost of
    external finance.

16
Financial Frictions in Action Pecking Order
Theory of Financing
  • Firms use financing with smallest adverse
    selection costs (i.e., smallest information
    asymmetries) first.
  • Pecking order
  • Internal Funds
  • Bank Debt
  • Public Debt
  • Public Equity

17
Financial Frictions in Action Pecking Order
Theory of Financing
  • Implications
  • Financial slack is valuable.
  • Observed capital structures reflect availability
    of positive net present value projects.
  • No optimal debt/equity mix.

18
Asymmetric-Information Costs Moral Hazard
  • Principal-Agent Problem Principal designates
    agent to act on his behalf. Because monitoring/
    disciplining are costly, agent has scope to
    pursue his own interest at the expense of
    principal.
  • Examples
  • Separation of ownership from control allows
    managers to use firm resources to pursue personal
    interests instead of maximizing shareholder
    value.
  • Separation of savers/investors allows investors
    to use surplus funds to pursue personal interests
    rather than accepting capital projects with
    highest NPV.

19
Asymmetric-Information Costs Moral Hazard
  • Solutions to moral-hazard problems
  • Debt finance
  • Motivates managers to maximize shareholder value
    by absorbing free cash flow
  • Reduces costs of monitoring investors
  • Government regulation
  • Financial intermediation

20
Asymmetric-Information Costs Moral Hazard
  • Features of debt contracts that reduce
    moral-hazard problems
  • Restrictive covenants
  • Collateral requirements
  • Net worth requirements
  • Reputation (a form of collateral or net worth)

21
Catalysts in Financial Markets
Economic and Political Shocks
  • ? Technology

? Transactions Costs ? Information Costs
? Relative Return from Granting Rents
? Taxation and Regulation
? Shape of financialintermediaries and markets
22
Catalysts in Financial Markets
  • Technological improvements
  • Advances in finance and statistical theory
  • Advances in computing speed, power, and storage
    space
  • Advances in transportation and telecommunication

23
Regulation of Financial Markets
  • Justification (according to Mishkin)
  • 1. Increase Information to Investors
  • Decreases adverse selection/moral hazard problems
  • 2. Ensuring Soundness of Financial Intermediaries
  • Chartering, reporting requirements, restrictions
    on assets and activities, deposit insurance, and
    anti-competition measures.
  • 3. Improving Monetary Control
  • Reserve requirements
  • Deposit insurance

24
Regulation of Financial Markets
  • Two better reasons (in MDVs view)
  • Hysterical political reaction to real/ perceived
    crisis
  • Rent seeking
  • Use of government power to secure return above
    opportunity cost (economic rents)

Technological and political/economic shocks
alter returns to taxing/regulating.
25
Regulation of Financial MarketsGlass-Steagall
Act (1933)
  • Example of hysterical political reaction to real
    or perceived crisis plus rent seeking
  • Glass-Steagall (1933)
  • Established firewall between investment and
    commercial banking.
  • Based on idea that investment banking would
    increase risk of commercial banking and conflict
    of interest existed.

26
Regulation of Financial MarketsGlass-Steagall
Act (1933)
  • But...
  • Portfolio theory indicates combining commercial
    and investment banking actually reduces risk.
  • Evidence from 1920s indicates bonds underwritten
    by investment bank subs of commercial banks
    performed well (no evidence of massive fraud).
  • Public benefits from economies of scope available
    by combining commercial and investment banking.

27
Recent Trends in Financial Markets
  1. Financial entrepreneurship
  2. Globalization
  3. Democratization
  4. Deregulation
  5. Evolution of financial intermediation

All these trends have their roots in
technological or political/economic shocks!
28
Questions over
Money and Banking Mr. Vaughan
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