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Homework answers / question archive / 1)Why Stocks are not the most important source of external financing for businesses
1)Why Stocks are not the most important source of external financing for businesses.
2)List tools to Help Solve Adverse Selection (Lemons) Problems
3)Discuss the agency theory
Stocks are not the most important source of external financing for businesses :
Stocks are not the most important source of external financing for businesses because issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.
Indirect finance which involves the activities of financial intermediaries, is many time more important than direct finance, in which businesses raise funds directly from lenders in financial markets.
Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.
The financial system is among the most heavily regulated sectors of economy.
Only large well established corporations have easy access to securities markets to finance their activities.
Tools help to solve Adverse Selection (Lemons) Problems :
Adverse selection occurs when one party in a transaction has better information than the other party.
Lemon Problems: If we can't distinguish between good and bad securities ("lemons") , we will be willing to pay only the average price of good and bad securities.
Result : Good securities shall be undervalued and firms won't issue them; bad securities overvalued so too many issued
Consequense : Investors know that mainly bad securities shall be marketed, so they won't want to buy them, and market not function well.
Tools to solve Adverse Selection:
• General way to solve adverse selection : Reduce information asymmetry.
• Concrete ways that deal with the problem :
A. Private production and Sale of information
*Example: Moody's, S&P, Dun & Bradstreet, Fitch
*But: "Free-riders" interfere with this solution, buying same securities as purchaser of information and hence lowering value of securities.
B. Government regulation to increase information
*Example : SEC / CONSOB
*For example : Annual audits of public corporations
* But: Does regulation eliminate the problem? (Ex- Parmalat) - window dressing
C. Financial Intermediation
*By specializing in collecting information, intermediaries have a better way of selecting the good credits.
*By selecting the best credits, they may earn better expected returns than average market investor, and can pay for deposits
*Avoids free rider problem by making private loans
*This explains why financial intermediaries are most important sources of finance for firms.
D. Collateral and Net Worth
*If debt is baked up with collateral, then in case of default the lender can seize the collateral and sell it to recuperate his investment
*Collateral has reduces credit risk, the risk that your counterparty doesn't repay
*Similar role of net worth (difference between assets and liabilties). If net worth is high, lender may take title to the firm's net worth in case of default
*Explains why collateral is a recurrent feature in debt contracts
Agency Theory :
Agency theory is a management and economic theory that attempts to explain relationships and self-interest in business organisations. It describes the relationship between principals/agents and delegation of control. It explain how best to organise relationships in which one party (Principal) determines the work and which another party (Agent) performs or makes decisions on behalf of the Principal.
During 1960s & 1970s, economist explored risk sharing among individual and groups. Thus literature described the risk sharing problem is one that arises when co-operating parties have different attitude towards risk.
Agency theory broadened this risk sharing literature to include the so called agency problem that occurs when co-operating parties have different goals and division of labour.
Agency theory says both Principal and Agent act in their own self-interest, which can work for their mutual benefit. Top management for example, is motivated by high pay or corporate perks. To keep these things, they maximize the shareholders' return. Owners are motivated to reward capable executives because they generate profits.
The agency theory considering the potential conflict of interest between shateholders and management may arise as a result of several factors include:
Reward to management; Risk attitude of management and Shareholders; Takeover decisions by management; Time horizon of management.