Under Investment & Debt Overhang:

Debt overhang is the condition of an organization (for example, a business, government, or family) that has existing debt so great that it cannot easily borrow more money, even when that new borrowing is actually a good investment that would more than pay for itself.

This problem emerges, for example, if a company has a new investment project with positive net present value (NPV), but cannot capture the investment opportunity due to an existing debt position, i.e., the face value of the existing debt is bigger than the expected payoff. Hence, the equity holders will be reluctant to invest in such a project because most of the benefits will be reaped by the debt holders. In addition, debt holders will not finance the firm if the company cannot convince the debt holders that the project will not fail.

A debt burden that is so large that an entity cannot take on additional debt to finance future projects, even those that are profitable enough to enable it to reduce its indebtedness over time. Debt overhang serves to dissuade current investment, since all earnings from new projects would only go to existing debt holders, leaving little incentive for the entity to attempt to dig itself out of the hole. In the context of sovereign governments, the term refers to a situation where the debt stock of a nation exceeds its future capacity to repay it.

A debt overhang can trap companies and countries in a vicious downward spiral, as a greater proportion of cash flow or revenues go to servicing existing debt, creating an operating deficit that can only be filled through incremental debt, which adds to the debt burden.

Countries faced with debt overhang face steady erosion in living standards, due to reduced spending in vital areas such as education, health and infrastructure.

Eventually, the only way out of a debt overhang is either through forgiveness of part or most of the debt by creditors, through bankruptcy for a company or debt default by a nation. 

LEMONS:

The issue of information asymmetry between the buyer and seller of an investment or product. Lemons problem was popularized by a 1970 research paper by economist George Akerlof. The term is derived from Akerlof's demonstration of the concept of asymmetric information through the example of defective used cars, which are known as lemons in marketplace. In the investment field, the lemons problem is apparent in areas such as insurance and corporate finance.

“LEMONS PROBLEM'

Information asymmetry arises when the parties to a transaction do not have the same degree of information necessary to make an informed decision. For example, in the market for used cars, the buyer generally cannot ascertain the value of a vehicle accurately and may therefore only be willing to pay an average price for it, somewhere between a bargain price and a premium price. However, this tilts the scales in favour of a lemon seller, since even an average price for this lemon would be higher than the price it would command if the buyer knew beforehand that it was indeed a lemon. This phenomenon also puts the seller of a good used car at a disadvantage, since the best price such a seller can expect is an average price, and not the premium price the car should command.

Moral hazard

The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Moral hazard can be present any time two parties come into agreement with one another. Each party in a contract may have the opportunity to gain from acting contrary to the principles laid out by the agreement. For example, when a salesperson is paid a flat salary with no commissions for his or her sales, there is a danger that the salesperson may not try very hard to sell the business owner's goods because the wage stays the same regardless of how much or how little the owner benefits from the salesperson's work. 

Moral hazard can be somewhat reduced by the placing of responsibilities on both parties of a contract. In the example of the salesperson, the manager may decide to pay a wage comprised of both salary and commissions. With such a wage, the salesperson would have more incentive not only to produce more profits but also to prevent losses for the company.

Agency cost of Managerial Discretion:

A type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal. Agency costs arise because of core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders.

Some common examples of the principal-agent relationship include: management (agent) and shareholders (principal), or politicians (agent) and voters (principal).

Agency costs are inevitable within an organization whenever the principals are not completely in charge; the costs can usually be best spent on providing proper material incentives (such as performance bonuses and stock options) and moral incentives for agents to properly execute their duties, thereby aligning the interests of principals (owners) and agents.

We argue that management sells assets when doing so provides the cheapest funds to pursue its objectives rather than for operating efficiency reasons alone. This hypothesis suggests that (1) firms selling assets have high leverage and/or poor performance, (2) a successful asset sale is good news and (3) the stock market discounts asset sale proceeds retained by the selling firm. In support of this hypothesis, we find that the typical firm in our sample performs poorly before the sale and that the average stock-price reaction to asset sales is positive only when the proceeds are paid out.

Measures of the quality of trading in a stock

Healthy revenue and profit margins are crucial to any company. However, monitoring your bottom line is only one part of the formula. It’s essential that you determine the factors critical to your company’s success, measure those metrics and put into place a system for continually improving performance. Here are ten guidelines for helping you develop your company’s process.1. Define Your Goals: Determine your measures for success. Make your goals challenging, but achievable.

Do you want to increase customer retention, improve market share, penetrate a new market segment, change a perception, generate more store traffic, reduce customer complaints? Be specific and make your objectives measurable. For example, by what percentage do you want to increase sales?

2. Determine the Metrics to Measure Your Company’s Performance: Compile a list of factors that are

important in your industry. Criteria may include:

 Marketing: sales growth; market share; distribution methods; sales force size, effectiveness and training; advertising budget and effectiveness; inventory levels, delivery time; product quality; customer retention rates Production: plant capacity, locations and age; age of equipment; ability to expand capacity; skill and turnover of labor force; union relations; quality control; supplier retention; raw material sources Administrative: employee turnover, age of facilities Management: experience, depth and turnover of top, middle and supervisory managers; effectiveness of communication systems; access to information; cohesiveness of top management ranks; compensation plans; decision-making speed; strategic planning ability

Technology/Research & Development: age of R&D facilities; age of production technology; production patterns; basic innovation; engineering abilities; experience of R&D team; R&D budget; R&D project timelines

3. Develop Methods to Collect and Organize Data: Determine a process for tracking and reporting all relevant data. Report on trends that emerge from your findings on a regular basis.

4. Compare Yourself to the Competition: You can glean a lot by doing your homework, including shopping your competitors. Also check:

Annual and 10 K reports on public companies Internet search engines by competitors' names or key words Trade associations and publications Business and general press as well as press releases Government agencies Private research firms, including online computer databases

5. Conduct Research: When you need specific information about your customers and prospects that doesn’t exist, conduct your own primary research.

There are two types of research: qualitative and quantitative. Qualitative research is used to understand why customers behave as they do or to develop hypotheses about that behavior. Personal interviews and focus groups (a meeting of 8-12 carefully selected people) are two examples of this semi-structured type of survey. Quantitative research is a highly structured form that attempts to answer how much. Numbers can be projected to the universe that the sample represents. Telephone, online and mail surveys are examples.

6. Understand Your Strengths and Weaknesses: Rate your company on your developed list of metrics in comparison to your competitors. Look for clusters of strength that may give you a competitive advantage.

7. Focus on Customer Retention: Customer retention is a matter of business survival, as getting a new customer is five times more expensive than retaining a current one.

Work on core product and service attributes to build customer loyalty (such as treating each customer as a valued individual). Businesses must focus on such issues as instilling a helpful staff attitude, delivering on advertising promises, developing a favorable return policy and providing accurate product information. Use your success with current customers to attract new referral business, but also remember that not every customer is worth keeping. You cannot be all things to all people. Sometimes, you have to let customers go and train energies on those clients who are the best fit.

8. Measure Marketing Effectiveness:  Effective measurement lays the groundwork for future plans, so keeping track of results is the only way to improve your marketing efforts. The key is determining which data should be collected. Your marketing results may be measured in sales (dollars or units), market share, store traffic, number of inquiries or reduced complaint rates, or other metrics. Tracking can also be based on surveys that assess customer perceptions.

9. Track Employees: Having top employees who are motivated is critical to your company’s success.

Track the effectiveness of your recruitment methods and retention levels as well as employee satisfaction and performance.

10. Apply the Information: Analyze the intelligence you’ve collected, draw conclusions and make recommendations based on it. Develop a plan forseeking out opportunities to demonstrate your company’s strengths. If weaknesses are critical drawbacks to your company’s success, develop a plan for overcoming them.

The Put-Call Parity Theorem

In financial mathematics, put–call parity defines a relationship between the price of a European call option and European put option, both with the identical strike price and expiry, namely that a portfolio of a long call option and a short put option is equivalent to (and hence has the same value as) a single forward contract at this strike price and expiry. This is because if the price at expiry is above the strike price, the call will be exercised, while if it is below, the put will be exercised, and thus in either case one unit of the asset will be purchased for the strike price, exactly as in a forward contract.

The validity of this relationship requires that certain assumptions be satisfied; these are specified and the relationship derived below. In practice transaction costs and financing costs (leverage) mean this relationship will not exactly hold, but in liquid markets the relationship is close to exact.

Put–call parity can be stated in a number of equivalent ways, most tersely as:

Theorem 1 For a given time to expiration t and strike price E let:

S = the current value of a non-dividend paying stock or other asset.

P = the current value of a European put option on the asset with strike price E and time to expiration t.

B = the current value of a risk-free zero-coupon bond with value at maturity E and time to maturity t.

C = the current value of a European call option on the asset with strike price E and time to expiration t.

Then in the absence of arbitrage opportunities:

S + P = B + C

Corollary 1 If r is the current risk-free continuously compounded interest rate for time period t then:

S + P = e−rtE + C

Corollary 2 If E = S ert = the forward price of the asset, then C = P.

Inforamtion Assymetry:

Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other(s) do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other(s) cannot.

In adverse selection models, the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. An example of adverse selection is when people who are high risk are more likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints. An example of moral hazard is when people are more likely to behave recklessly after becoming insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance.

The classic paper on adverse selection is George Akerlof's "The Market for Lemons" from 1970, which brought informational issues at the forefront of economic theory. It discusses two primary solutions to this problem, signalling and screening.

SignalingMichael Spence originally proposed the idea of signaling. He proposed that in a situation with information asymmetry, it is possible for people to signal their type, thus believably transferring information to the other party and resolving the asymmetry.

This idea was originally studied in the context of looking for a job. An employer is interested in hiring a new employee who is "skilled in learning." Of course, all prospective employees will claim to be "skilled at learning", but only they know if they really are. This is an information asymmetry. Skill in learning is malleable, and depends upon many factors, including diet, exercise and money.

Spence proposes, for example, that going to college can function as a credible signal of an ability to learn. Assuming that people who are skilled in learning can finish college more easily than people who are unskilled, then by finishing college the skilled people signal their skill to prospective employers. No matter how much or how little they may have learned in college or what they studied, finishing functions as a signal of their capacity for learning. However, finishing college may merely function as a signal of their ability to pay for college, it may signal the willingness of individuals to adhere to orthodox views, or it may signal a willingness to comply with authority.

ScreeningJoseph E. Stiglitz pioneered the theory of screening. In this way the under informed party can induce the other party to reveal their information. They can provide a menu of choices in such a way that the choice depends on the private information of the other party.

Examples of situations where the seller usually has better information than the buyer are numerous but include used-car salespeople, mortgage brokers and loan originators, stockbrokers and real estate agents.

Examples of situations where the buyer usually has better information than the seller include estate sales as specified in a last will and testament, life insurance, or sales of old artpieces without prior professional assessment of their value. This situation was first described by Kenneth J. Arrow in an article on health care in 1963.

George Akerlof in The Market for Lemons notices that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality. Because of information asymmetry, unscrupulous sellers can "spoof" items (like replica goods such as watches) and

defraud the buyer. As a result, many people not willing to risk getting ripped off will avoid certain types of purchases, or will not spend as much for a given item. It is even possible for the market to decay to the point of nonexistence.The pecking order theory In corporate finance, pecking order theory (or pecking order model) postulates that the cost of financing increases with asymmetric information. Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a “last resort”. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance.

The pecking order theory is popularized by Myers and Majluf (1984) [1] when they argue that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance The pecking order theory suggests that firms have a particular preference order for capital used to finance their businesses (Myers and Majluf, 1984). Owing to the information asymmetries between the firm and potential investors, the firm will prefer retained earnings to debt, short-term debt over long-term debt and debt over equity. Myers and Majluf (1984) argued that if firms issue no new security but only use it’s retained earning to support the investment opportunities, the information asymmetric can be resolved. That implies that issuing equity becomes more expensive as asymmetric information insiders and outsiders increase. Firms which information asymmetry is large should issue debt to avoid selling under-priced securities. The capital structure decreasing events such as new stock offering leads to a firm’s stock price decline.An announcement of increasing capital structure events is received by the market as good news because financial intermediaries like investment bank can become insiders to monitor the firm’s performance. Managers may have inside information that is not known to the market. Insider investors have more information about the true distribution of firm returns than outsiders. Insider investors tend to limit the use of equity in order to retain control of the firm (Hutchinson, 1995). Moreover, the risk of the firm’s return is unknown to investors. They are forced to rely on noisy signals such as the firm’s level of capital structure to determine the risk of their investment and firm’s value may be under-priced by the market (Myers and Majluf, 1984).Pecking order theory starts with asymmetric information as managers know more about their companies prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. There therefore exists a pecking order for the financing of new projects.

Asymmetric information favours the issue of debt over equity as the issue of debt signals the boards confidence that an investment is profitable and that the current stock price is undervalued (were stock price over-valued, the issue of equity would be favoured). The issue of equity would signal a lack of confidence in the board and that they feel the share price is over-valued. An issue of equity would therefore lead to a drop in share price. This does not however apply to high-tech industries where the issue of equity is preferable due to the high cost of debt issue as assets are intangible

OPTION DELTA:The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. Sometimes referred to as the "hedge ratio."

The option's delta is the rate of change of the price of the option with respect to its underlying security's price. The delta of an option ranges in value from 0 to 1 for calls (0 to -1 for puts)

and reflects the increase or decrease in the price of the option in response to a 1 point movement of the underlying asset price.

Far out-of-the-money options have delta values close to 0 while deep in-the-money options have deltas that are close to 1.

As the delta can change even with very tiny movements of the underlying stock price, it may be more practical to know the up delta and down delta values. For instance, the price of a call option with delta of 0.5 may increase by 0.6 point on a 1 point increase in the underlying stock price but decrease by only 0.4 point when the underlying stock price goes down by 1 point. In this case, the up delta is 0.6 and the down delta is 0.4.

For example, with respect to call options, a delta of 0.7 means that for every $1 the underlying stock increases, the call option will increase by $0.70. 

Put option deltas, on the other hand, will be negative, because as the underlying security increases, the value of the option will decrease. So a put option with a delta of -0.7 will decrease by $0.70 for every $1 the underlying increases in price.

As an in-the-money call option nears expiration, it will approach a delta of 1.00, and as an in-the-money put option nears expiration, it will approach a delta of -1.00.

Trade-off theory of capital structure:

The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger. Who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the literature is provided by Frank and Goyal.

An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

List out the means of mitigating the effects of information asymmetry in the credit markets:

Credit ratings are often viewed as important assessments of firms’ underlying credit risk as certified by rating agencies such as Moody’s and Standard and Poor’s (S&P). Without such certification or some means of reliably transmitting relevant credit information, firms who want to borrow from the public debt and loan markets may not be able to do so. For example, in the presence of information asymmetry, investors would not only face adverse selection problems, but would also incur high costs from credit analysis and monitoring. Thus, without any certification of a firm’s risk profile, investors would be reluctant to lend money to the firm (Sufi (2006)). Credit ratings may also contain information on firms’ credit quality beyond other publicly available information. For instance, firms may be reluctant to release information to the market that would compromise their strategic programs, in particular with regard to competitors.

Credit ratings in comparison allow them to incorporate inside information without disclosing specific details to the public at large.

Indeed, during the rating process, corporations often provide rating agencies with detailed inside information such as five-year forecasts and Pro - forma statements and other internal reports. Moreover, credit agencies are specialized financial

Intermediaries in the information gathering and evaluation process and thereby could provide more reliable measures of a firm’s credit worthiness. In addition to providing credit information to investors, credit ratings are also parts of government regulations on financial institutions and other intermediaries. Since 1936 and 1989, banks and Savings and Loans, respectively, have been prohibited from investing in junk bonds (Cantor and Packer (1995)). More recently,

Congress has established the “AA” or “Aa” rating as the cutoff in determining the eligibility of mortgage-related securities and foreign bonds as collateral for margin lending. Furthermore, the

National Association of Insurance Commissioners has adopted capital rules that give the most favorable capital charge to bonds rated “A” or above (Cantor and Packer (1995)).

Prior to 1982, Moody’s assessed and reported firms’ creditworthiness using nine broad rating classes ranging from an “Aaa” rating that forecasts virtually no default risk for the foreseeable future to a “C” rating that indicates a state of default. On April 26, 1982, Moody’s switched to a more refined rating reporting system by introducing numerical modifiers to their formerly coarse rating classes.

More specifically, within each of the selected broad rating classes, Moody’s assigned rating modifiers of “1,” “2,” and “3” to represent sub-ratings of best, average, and worst credit quality.

Miller equilibrium

Since we assume that the capital market is perfectly competitive, the equilibrium in Miller’s model (or,

Miller equilibrium as it is sometimes referred to in the literature) is achieved when demand and the supply

curves intersect, i.e., when BD(r) = BS(r). As Figure shows, this happens on the horizontal part of the demand curve where r = r0/(1 - tC). Since at this point the cost of equity and the cost of debt are the

same, it follows that in equilibrium, each firm is just indifferent to its capital structure. That is, if a firm

needs to raise an additional dollar, it will be completely indifferent between raising by issuing equity or

by issuing corporate bonds.

Consequences of Violations of the assumptions of Ideal Capital Market:

Asset allocation is one of the most important decisions related to investment in the capital market. There are a number of risk factors related to these investments, and because of this appropriate capital market analyses are necessary. There are firms which provide capital market investment solutions to investors, each making their own risk and return calculations, or capital market assumptions. These assumptions are followed strictly when making suggestions to the clients regarding the asset allocation. 

Many companies also provide their clients with their capital market assumptions so that the clients can evaluate their own investment decisions. Of course, capital market assumptions cannot be permanent and thus need to be changed from time to time. The market prices of different investment instruments change very rapidly, and with this rapid change the level of risk also changes. Different consultation companies use different techniques to get their perfect capital market assumptions. However, most companies concentrate on valuations because they can provide the most accurate capital market assumptions for the future. Other factors useful in making capital market assumptions are the ratio between the price and earning of the particular asset, the dividend yield, the interest rates, and the growth rate of the assets. 

Apart from the internal factors of the capital market, there are also macroeconomic trends that are related to making capital market assumptions. These include the level of inflation, changes in the Gross Domestic Product (GDP), and increases or decreases in the unemployment rate. International external factors related to the capital market which play a major role in shaping capital market assumptions too include taxation, foreign denominations, and decisions of national regulators. 

r0/1-t Bs( r )

BD( r )

r0

BD B* B

Financial Distress:

Financial distress is a term in corporate finance used to indicate a condition when promises to creditors of a company are broken or honoured with difficulty. If financial distress cannot be relieved, it can lead to bankruptcy. Financial distress is usually associated with some costs to the company; these are known as costs of financial distress. Common examples of a cost of financial distress are bankruptcy costs. These direct costs include auditors' fees, legal fees, management fees and other payments. Cost of financial distress can occur even if bankruptcy is avoided (indirect costs).

Financial distress in companies requires management attention and might lead to reduced attention on the operations of the company.

Another source of indirect costs of financial distress are higher costs of capital as usually banks increase the interest rates if a state of financial distressed occurs.