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Advanced Corporate Finance

(Econm 2032)

Revision lecture

Piotr Korczak
P.Korczak@bristol.ac.uk

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Summary of the material covered in ACF
• Agency conflicts / incentive problems
– Managers – claimholders conflicts
– Equity holders – debt holders conflicts
– Firms – underwriters conflicts
• Information asymmetry issues
– Between managers and investors
– Bewteen different groups of investors
– Market timing
• Other issues covered
– Strategic decisions (IPO, M&A)
– Financing choices and strategy

3 Information asymmetry

Moral hazard Adverse selection

and agency problems and signalling

Information asymmetry Uninformed parties act on the

makes it difficult to monitor
agent’s actions
•Full information about the agent’s
performance is difficult to obtain or
the factor is unobservable
•Agents pursue their own interests
basis of average characteristics
•They are unable to distinguish
between good and bad firms
•Good firms signal their quality using
a signal that is too costly for bad
firms to mimic

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Agency and incentive problems (1)
• Separation of ownership and control
– Conflicts between managers and claimholders, mainly
shareholders
– Jensen and Meckling (1976) theory
• Moral hazard
– Insufficient effort
– Extravagant investments
• Including M&As
– Entrenchment strategies
• Including antitakeover defence strategies
– Self-dealing

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Agency and incentive problems (2)
• Disciplining mechanisms
– Leverage
– Compensation, including equity-based compensation
– Legal protection and codes of good practice
– Board of directors
– Concentrated ownership and large holdings
• Including the role of institutional investors
– Takeovers
• Including leveraged buy-outs linked also to the mechanisms
listed above

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Agency and incentive problems (3)
• Equity holder – debt holder incentive problems
– Priority of DH over EH, limited liability of EH
– Debt and equity as options
– Indirect costs of financial distress
• Suboptimal investment strategies
– Underinvestment (debt overhang)
– Asset substitution
– Short-sighted investment problems
– Reluctance to liquidate

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Agency and incentive problems (4)
• Mechanisms to limit EH-DH incentive problems
– Protective covenants
– Bank and privately placed debt
– Short-term debt
– Security design
– Project finance
– Compensation contracts
• Agency conflicts between issuers and underwriters
– Lead to IPO underpricing

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Information asymmetry issues (1)
• Signalling with the level of debt
– High-quality firms may take a leverage higher than
otherwise preferred to distinguish themselves from low-
quality firms
• Signalling with the level of IPO underpricing
– High-quality firms can afford ‘leaving money on the
table’
• Suboptimal investment and pecking order of
financing
– Unwilling to issue securities that are undervalued
(managers know and investor do not know they are
undervalued)

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Information asymmetry issues (2)
• Information asymmetries in the IPO market, lead
to IPO underpricing
– Investors better informed (e.g. about the demand) than
the firm
– Investor differentially informed
• Winner’s curse
• Negative information cascade

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Information asymmetry issues (3)
• Market timing
– Managers are able to recognise when securities are
mispriced
• Repurchase decisions
• Share issue decisions including IPOs
• As a consequence, a strong impact on capital structure
• Choice of the method of payment in acquisitions

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Other issues (1)
• Initial public offerings
– Costs and benefits of going public
– IPO waves
– IPO underpricing arguments not based on agency or
asymmetric information arguments
• Including litigation risk, corruption hypothesis
– Long-run performance
• Including measurement problems

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Other issues (2)
• Mergers and acquisitions
– Also closely linked to agency problems and information
issues
– Three types: strategic, financial and conglomerate
– Conglomerates – advantages and disadvantages of
corporate diversification
• Including internal capital markets
• Diversification discount puzzle

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Other issues (3)
• Capital structure and corporate strategy
– Stakeholder considerations, including
• Buyer-supplier relationship
• Bargaining with labour unions and with the government
– Competition considerations
• Are highly leveraged firms more or less aggressive
competitors?
• Risk of predation

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