Consider a firm where the effort undertaken by managers can affect cash flows in

Question

Consider a firm where the effort undertaken by managers can affect cash flows inthe next period. For simplicity, assume managers either exert low effort or higheffort. Assume that investors cannot observe effort.
a) Assume that, with low effort, the firm realizes XL with certainty and, withhigh effort, the firm realizes XH with certainty. If cash flows can beobserved by investors, is there asymmetric information between

investors and managers? Explain.

b) Now assume that, with low effort, the firm earns XL  with probability qand XH with probability (1-??q). With high effort, the firm realizes XL withprobability p and XH with probability (1-??p). If q > p, is there asymmetricinformation between investors and managers? If so, is it hidden

information or hidden action? Explain.

c) Assume that in bankruptcy, the managers are dismissed without

collecting bonuses. Assume no taxes or costs of bankruptcy. Would higherlevels of debt raise the value of the firm? Explain.

Finals coming up and I have trouble with some problem sets. Please help.

Explanation / Answer

a.

Here, two parties are managers and investors. Efforts of manager is going to affect the cash flows . But efforts contribute many combinations who ultimately result in one cash flow that is visible to investor. Now, Investor can observe and analyze the cash flow but cannot assess the pinpoint reason of that particular cash flow. Though , this reason is well known to a manager. So, it is a case of asymmetric information between investors and managers. It is also supported by the fact that efforts have two parts explicit and implicit. Here, Implicit part cannot be assessed by the investors though it is well known to manager.    

b.

With Low Effort:

Expected Earning = XL*q    + XH*(1-q)

With high Effort:

Expected Earning = XL*p   + XH*(1-p)

P > q

In the given scenario, only expected earnings will be available to investor , so it will again be the case of asymmetric information between investors and managers.

Also, hidden action will also play a role as implicit actions are not known to investors.

c.

It is a generally observed that cost of debt is less than cost of equity. But, with increase in debt level in a company, financial risk also increases which can put the status of a company in danger (Bankruptcy / Liquidation). Also, with high level of debt, cost of debt and cost of equity also increases. With the increase in cost of sources of capital, value of the firm decreases. So, it can be said that, only a judicious level of debt will raise the value of the firm and high level of debt will not raise the value of the firm.

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