Theory of Corporate Finance - Essay Sample

Explain Within the Moral Hazard Framework Introduced in The Lecture Why It Makes Sense for a Company Not Only to Use Long-Term but Also Short-Term Debt!

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A moral hazard framework may arise when two parties enter into a contract, and either party may gain from acting against the tenets stipulated in the agreement. According to Tirole (2006), in moral hazard, a party in a contractual agreement may have an incentive to take abnormal risks in a distressed attempt to earn a profit before the contract settles. A moral hazard arises when a party in a contract can assume additional risks leading o severe implications to the other party. A party may limit the consequence of risk, leading to an increase in the possibility of a moral hazard. In credit contracts, a moral hazard exists if the project is financed with somebody else's money, which makes the investor less careful.

Combining long-term and short-term to finance the company’s operations allows the borrower to be consistent and trusted in implementing net present value (NPV). Long-term and short-term debts burden the borrower and prevent the firm from taking the NPV maximizing plan. Long-term debt provides a company with cost advantages and gives the management financial benefit since interest rates are usually lower ((Tirole, 2006). Also, it gives the management debt control since the company pays the lender in small installments, and the payment period is spread out. Combining long-term and short-term debt financing allows a firm to diversify its capital portfolio by providing greater flexibility and resources to finance different operational needs. As a result, it minimizes the company’s reliance on a specific capital source and enables the management to spread its debt maturities.

Explain Conflicts Between Old and New Lenders Over New Investment Opportunities and Why It Makes Sense to Write Debt Covenants!

Conflicts exist between old and new lenders over new investment opportunities. According to overborrowing threatens to impact the determination of the initial investor’s value severely. The new lender joins a new investment opportunity with the expectation of a low success probability. The new lender may demand a higher rate of return due to the low information he gets regarding the risks involved in the investment project. As a result of the higher returns paid to the new lender, it leads to conflicts since the old lender gets a low value of the invested capital. Also, inviting a new lender leaves the initial investor exposed even though their claims may have similar or higher seniority. According to Tirole (2006), mutual gain for lenders and borrowers motivates the effective performance of the credit based on the investment projects preferred by investors. However, lending is worthwhile when the returns generated are equal to that obtained in alternative opportunities.

Writing a debt covenant is a significant aspect of lending. Debt covenants are limitations that lenders put on debt holders to limit further actions of the borrower. Debt covenants do not place a burden on the debt holder, but they are useful in aligning interest rates and resolving agency problems. According to Tirole (2006), a covenant in debt might forbid further debt issues and prevent overborrowing, putting lenders investment at higher risk. In most cases, many debtors want to evade more senior debt, which consumers part of the invested capital. Debt restrictions also benefit the debt holder by minimizing the cost of borrowing. As a result, imposing restrictions will allow the borrower to negotiate lower interest rates to accommodate for the abiding by the limitations.

What Does the Pecking Order Hypothesis State and How Can It be Explained in an Asymmetric Information Framework?

The pecking order hypothesis states that an enterprise should first finance itself internally through retained earnings (Tirole, 2006). If retained earnings are not available or they are insufficient, the company can opt for debt. Issuing new equity is the last resort if the organization does not have retained earnings and debt financing. Pecking order is a significant hypothesis since it indicates how an organization is performing financially. According to Tirole (2006), if a firm manages to finance its operations internally, it shows it is strong while financing through debt, which means that the managers are confident that the company will meet its obligations to the lenders. Financing company operations through the issuance of new equity signify danger since the management might perceive its stock is overpriced and therefore intends to make money before the stock price declines. As a result, the management should scrutinize its capital structure accurately to improve the cost of capital and enhance profitability.

Asymmetry information framework provides that an imbalance of information between buyers and sellers may lead to market failure. Pecking order theory can be explained in the asymmetry information framework in the sense that company managers are buyers and the lenders are the sellers. Organizational management possesses significant information regarding the performance of an enterprise, risks involved, and future outlook (Tirole, 2006). Compensation for information symmetry requires lenders to demand higher return rates to meet the higher risks involved. Financing an organization through retained earnings diminishes information asymmetry since finances come from the organization. However, seeking external financial support such as debt and equity will require higher returns since creditors and investors possess limited information. In most cases, management prefers debt over equity when seeking external finance due to the lower cost of debt compared to equity.

Reference

Tirole, J. (2006). The theory of corporate finance. Princeton and Oxford