Financial Economics, Fall 2008
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財務管理(Financial Management) + 經濟學觀念
從財務長(Chief Financial Officer, CFO)的地位與角度，探討現代企業所面臨的投資決策(investment decision)與融資決策(financing decision)課題，兼具理論
Brealey, Myers, and Allen, Principles of Corporate Finance, 9th ed., 2008(華泰
Brealey, Myers, and Allen, Principles of Corporate Finance, Concise Edition,
1st ed., 2009(雙業代理)
期末討論 60% (每位學生找一篇期刊論文，在課堂上報告並供大家討論。)
1. The Economic Analysis of Financial Structure (Ch. 14 from Mishkin and Eakins)
2. Introduction (Ch.1 from Brealy and Myers)
3. Present Value and the Opportunity Cost of Capital
a) Introduction to PV (Sec. 2-1)
b) Foundations of the NPV Rule (Sec. 2-2 and 2-3)
c) How to Calculate PVs – Part I (Sec. 3-1)
d) Cash Flows (Sec. 6-1 and 6-2)
e) The Opportunity Cost of Capital (Sec. 5-1)
f) How to Calculate PVs – Part II (Sec. 3-2 and 3-3)
g) Valuing Bonds (Sec. 3-5)
4. Other Topics on the NPV Rule
a) Why NPV Leads to Better Investment Decisions than Other Criteria (Sec. 5-3 and 5-4)
b) Mutually Exclusive Investment Alternatives and the NPV Rule (Sec. 6-3 and 6-4) 5. Valuing Common Stocks (Ch. 4)
a) Introduction to Risk, Return, and the Opportunity Cost of Capital (Ch. 7)
b) Risk and Return (The Capital Asset Pricing Model) (Ch. 8)
c) Capital Budgeting (Investment Decision) and Risk (Ch. 9) 7. Where Positive NPVs Come from? (Ch. 11)
8. Principal-Agent Problem in Capital Budgeting (Sec. 12-3 to 12-6)
9. Corporate Financing and Market Efficiency (Ch. 13)
10. The Dividend Controversy (Ch. 16)
11. Capital Structure (Ch. 17 and 18)
12. Capital Budgeting When Investment and Financing Decisions Interact (Ch. 19)
a) Valuing Options and Corporate Liabilities (Ch. 20)
b) Applications: Real Options (Ch. 21)
14. Warrants and Convertibles (Ch. 22)
15. Valuing Risky Debt and Term Structure (Ch. 23)
16. Risk Management (Ch. 26 and 27)
17. Mergers (Ch. 33)
Notes: a) Topics covered from Ch. 1 to Ch. 12 belong to investment decisions. Topics covered
from Ch. 13 to Ch. 33 belong to financing decisions.
b) The outline is for a two-semester course. The one-semester class will only cover the
first half of the outline (topics 1 to 8 in the list above).
An Economic Analysis of Financial Structure
function of financial system: moving funds from people who save to people who have
productive investment opportunities.
promote economic efficiency
economic analysis: using a few simple but powerful economic concepts to explain features of
the financial markets.
Basic Puzzles about Financial Structure
external funds of American nonfinancial businesses in the period 1970 – 1985 (Figure 1):
loans 61.9%, bonds 29.8%
Puzzle 1: Stocks are not the most important source of external financing for businesses.
a note: stock and flow concepts in footnote 1
Puzzle 2: Issuing marketable securities is not the primary way in which businesses finance
bonds plus stocks 31.9%
prevalent in industrialized countries (Canada is an exception) (Figure 2)
Puzzle 3: Indirect finance is more important than direct finance.
Direct finance is in effect used in less than 5% of the external funding of American business.
Puzzle 4: Banks are the most important source of external funds.
An extraordinary fact that surprises most people is that in an average year in the U.S. 25 times
more funds are raised with bank loans than with stocks.
Banks are even more important in countries such as France and in developing countries.
Puzzle 5: The financial system is among the most heavily regulated sectors of the economy.
Regulation: to promote the provision of information and to ensure the soundness of the
Puzzle 6: Only large, well-established corporations have access to securities markets to
finance their activities.
Puzzle 7: Collateral is a prevalent feature of debt contracts for both households and
collateral and collateralized (or secured) debt
Puzzle 8: Debt contracts are typically extremely complicated legal documents that place
substantial restrictions on the behavior of the borrower (restrictive covenant).
important feature of financial markets: substantial transaction and information costs
? economic analysis: How these costs affect financial markets will provide us with
solutions to the 8 puzzles.
transaction costs: the time and money spent in carrying out financial transactions.
How transaction costs influence financial structure:
Small savers are frozen out of financial markets (i.e., inability to access the markets and to
diversify their investments).
Ronald Coase’s transaction costs analysis:
The tendency of firms and markets is to adopt the organizational mode that best economizes on
the transaction costs.
How financial intermediaries reduce transaction costs:
economies of scale and expertise (e.g., legal advice and computer technology)
an important outcome: liquidity services provided by intermediaries
? Explain, in part, puzzle 3.
Asymmetric Information: Adverse Selection and Moral Hazard
asymmetric information: One party has insufficient knowledge about the other party involved
in a transaction to make accurate decisions.
Example: A borrower who takes out loans has better information than the lender about the
potential returns and risk associated with the projects he plans to undertake.
Lack of information creates problems in the financial system on two fronts:
a) adverse selection: the problem created by asymmetric information before the transaction
In financial markets, the potential borrowers who are the most likely to produce an
undesirable (adverse) outcome-the bad credit risks-are the ones who most actively seek out
a loan and are thus more likely to be selected.
=> result: Lenders may decide not to make any loans even though there are good credit
risks in the marketplace.
b) moral hazard: the problem created by asymmetric information after the transaction occurs.
In financial markets, the lender runs the risk (hazard) that the borrower might engage in
activities that are undesirable (immoral) from the lender’s point of view.
=> result: Lenders may decide that they would rather not make a loan.
Notes: a) Market failure occurs for the two cases above (i.e., few transactions and the markets
b) market failure in economics: Markets fail to reach economic efficiency, i.e., the
competitive equilibrium of neoclassical model.
The Lemons Problem: How Adverse Selection Influences Financial Structure
a famous article by George Ackerlof (1970): the lemons problem in the used car market
Potential buyers of used cars are frequently unable to assess the quality of the car. They are
thus willing to pay only a price reflecting the average quality. The owner of a used car, by
contrast, is more likely to know whether the car is a peach or a lemon.
? Few good used cars will come to the market because of underpricing.
? few sales
? market failure
lemons in the stock and bond markets
As a result of adverse selection, few good firms will sell securities in the markets to raise
capital because of undervaluing (market failure).
? The presence of adverse selection problems explains puzzles 2 and 1.
solutions to adverse selection problems:
a) private production and sale of information
examples: Standard and Poor’s, Moody’s, and Value Line
the free-rider problem: People who do not pay for information can take advantage of the
information that other people have paid for.
=> Less information is produced in the marketplace.
b) government regulation
two possibilities of government intervention:
i) produce and provide information to the public free of charge (politically difficult
ii) regulate securities markets in a way that encourage firms to reveal honest information
=>Explain puzzle 5.
i) Regulation relies on the financial statements which are based on historic data.
ii) Even firms provide information to the public, they still have more information than
iii) Bad firms have an incentive to slant information they are required to transmit to the
c) financial intermediation
a clue from the used-car market: Most used cars are sold by used-car dealers (intermediaries).
Used-car dealers produce information in the market and can avoid the free-rider
the key to bank’s success in reducing adverse selection problems in financial markets:
hold nontraded loans (private loans)
=> avoid the free-rider problem
=> be able to profit from the production of information
=> be willing to produce information
=> eliminate adverse selection problems
=> Explain puzzles 3 and 4.
a corollary of the analysis of bank’s role: huge improvements in information technology
implying that the lending role of banks should have declined (disintermediation).
a fact explained by the analysis: the greater importance of banks in the financial systems of
developing countries because information about private firms is even harder to collect in
corporations and adverse selection problems: The better known a corporation is, the more
information about its activities is available in the marketplace.
=> Investors will be willing to invest directly in the securities of well-known
=> Explain puzzle 6.
c) collateral and net worth
Collateral reduces the consequence of adverse selection.
? Lenders are more willing to make loans secured by collateral. Borrowers are willing to
supply collateral (a better loan rate).
? Explain puzzle 7.
Net worth (equity capital, the difference between a firm’s assets and it’s liabilities) can
perform a similar role to collateral:
i) If a firm defaults on its debt payments, the lender can take title to the firm’s net worth and
recoup some of the losses from the loan.
ii) Capital is a cushion of assets that can be used to pay off a firm’s debt. (ex ante)
more net worth => less likely to default, the consequences of adverse selection are less
=> lenders are more willing to make loans.
How Moral Hazard Affects the Choice between Debt and Equity Contracts
Moral hazard has important consequences for whether a firm finds it easier to raise funds with
debt rather than with equity contracts
moral hazard in equity contracts: the principal-agent problem
The separation of ownership and control involves moral hazard in that managers may act in
their own interest rather than in the interest of the stockholders because the managers have less
incentive to maximize profits than the stockholders (owners) do.
the cause of the principal-agent problem: Managers have more information about their
activities and actual profits than stockholders do.
tools to help solve the principal-agent problem:
a) production of information by owners: monitoring (auditing and checking)
two difficulties: i) Monitoring process can be expensive in terms of time and money (costly
ii) The free-rider problem decreases monitoring.
a note: incentive-compatible schemes in modern corporations (e.g., stock options)
b) government regulation to increase information: having laws to force firms to adhere to
standard accounting principles (partly effective)
c) financial intermediation
example: venture capital firms
features: i) Venture capital firms usually insist on having several of their own people
participate as the members of the managing body of the new business.
ii) The equity in the new business is not marketable to anyone but the venture
capital firm. => avoid the free-rider problem
d) debt contracts
attributes of debt contracts: Moral hazard would exist only in certain situations. That is,
only when firms have the trouble to meet their debt payments, is there a need for
the lenders to verify the state of firms’ profits.
=> less frequent need to monitor
=> lower cost of state verification
=> Explain puzzle 1.
How Moral Hazard Influences Financial Structure in Debt Markets
moral hazard in debt contracts:
Because a debt contract requires the borrowers to pay out a fixed amount and lets them keep
any profits above this amount, the borrowers have the temptation (or incentive) to take on the
investment projects that are riskier than the lenders would like. This temptation is strongest
when the net worth of the borrower is small.
a note: Usually managers and owners of firms refrain voluntarily from the temptation to play
on the lenders’ money, basing on pragmatic grounds: A firm or an individual makes a
killing today at the expense of lenders will be coldly received when the time comes to
tools to help solve moral hazard in debt contracts:
a) high net worth
When borrowers’ net worth is high, they have more at stake. => High net worth makes debt
incentive compatibility: High net worth aligns the incentives of the borrower with those of
the lender. That is, the greater the borrower’s net worth, the greater the borrower’s
incentive to behave in the way that the lender expects and desires.
b) monitoring and enforcement of restrictive covenants
four types of restrictive covenants:
i) keep the borrower from engaging in the undesirable activities (e.g., restrict from
purchasing other businesses).
ii) encourage the borrower to engage in desirable activities (e.g., maintain minimum
holdings of certain assets relative to the firm’s size).
iii) require the borrower to provide collateral and keep it in good condition.
iv) require the borrower to provide information about its activities periodically in the form of
accounting and income reports.
=>Explain puzzle 8.
problems with restrictive covenants:
i) impossible to write covenants that rule out every risky activity.
ii) costly monitoring and enforcement and the free-rider problem
c) financial intermediation
Banks primarily make private loans => avoid the free-rider problem on their monitoring and
enforcement of the restrictive covenants.