The Determination of Financial Structure Harvard Case Solution & Analysis

A managerial incentive-signaling equilibrium

By providing a significant role to the firm managers, there can be a validation of financial signals and moral hazard problems can be avoided by giving appropriate signaling for the value of firms A and B. To ensure good performance in this regard, the firm makes its managers liable for their decisions. The following assumption summarizes these points.

Assumption 1: Managers are well informed on all operations of the firm and have the competency of making informed decision. In addition, the firm financing its operations from outside financers will lead no information to the market.

Now not only the firm has to identify the role of managers but it also has to specify how they share in the consequences of their decision.

Assumption 2: Manager-insiders are compensated by a known incentive schedule i.e. a given rule which investors know.

Now in the model we assume that managers receive the following compensation,

Where VO and V1 are the respective values of the firm at time 0 and at time 1, and L is a penalty assessed on the manager if the firm gets bankrupt at time.

If value of debt repayment in year one is more than the value generated by the company in year one then yo and y1 are fixed non negative weights.

We shall assume that managers set a level a debt financing which in turn enhance their compensation.

The L represents the bankruptcy penalty imposed on managers; it does not represent the true bankruptcy cost on the firm.

Now managers have all the information of the firm, which they can easily trade in companies’ instruments in order to make personal gain inside trading. In case managers do so then the incentive schedule will not be given and moral hazard problems are another factor that stops them from doing so. The avoidance of such consequence is a clear goal of the management incentive structure.

Signaling Equilibrium

Let us suppose that investors use the face value of debt ‘F’ as a signal to identify the firm’s type. Let F* be critical level of financing. This will lead the value of Firm A being greater than critical level of financing, which will be equal or greater than the value of Firm B.

Therefore, when the face value of debt of a firm is greater than the critical level of financing it indicates that it is a A type firm and if the face value of debt of a firm is equal or lower than the critical level of financing then it will indicate that it is a B type of firm.

For these indicators to be accurate we must prove that investor’s assumptions are correct. That is all A type firms should set their face value of debt greater than critical level of financing and all B type firms should set their face value of debt equal or lower to critical level of financing.

If a firm signals itself as type A then it will set its value to be greater than its face value of debt; similarly type B firms will have their value equal or lower than its face value of debt and compensation of both managers will be set accordingly, where we have assumed that the manager will not expose himself to excessive risk of bankruptcy.

Suppose now Firm A manager chooses financial level, Fa, for , and Firm B managers choose Fb, for    . This is a signaling equilibrium where both managers will not have any incentive to change their signals.

The manager of firm B will be persuaded to truthfully indicate itself because the gain achieved by the manager through false statement is out weighted by the share of bankruptcy cost upon the manager that will be incurred. This is indicated by the equation.

Setting the Managerial Incentive Schedule 

Considering that payments were made to the insiders-managers for providing their services is w and all the managers are given proportional wage schedule that will lead to the fact that expected compensations will be equal to the wages provided. This is shown by

Hence manager A will find it in its interest to signal itself as Firm A whereas manager B will have no interest to follow A as it will lead to high risk of bankruptcy..................................

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