Deck 4: Information Asymmetry and the Markets for Corporate Securities

Question 1

Miller and Rock (1985) developed an ingenious signaling model in which _____by a firm serve as powerful signals of the firm's earnings capacity, and thus its value.Any such ____ reveal that the firm has been generating, and is expected to continue to generate, high net cash inflows.

A)cash payouts
B)debt issuance
C)equity issuance
D)earnings announcements

Answer 1

cash payouts

Question 2

According to the finance literature related to informational asymmetry, one of the most important roles of an investment-banking firm (in terms of assisting a firm in issuing securities to the public) is to vouch for the value of the security, after it has obtained confidential information from the firm's management about its business strategy.This vouching is known as:

A)certification
B)using a costly signal
C)private negotiation
D)establishing a reputation
E)contract enforcement

Answer 2

certification

Question 3

Leland and Pyle (1977) examine the effect of informational asymmetries on equilibrium corporate valuation and financial structure.The authors develop a signaling model and work through a specific example, focusing on optimal debt levels under conditions of asymmetric information.In their signaling model, an entrepreneur seeks financing for a project whose true value is known only to him.Clearly, direct transfer of information to lenders is impossible.Information may, however, be transferred by a credible signal.Here, the signal is:

A)the entrepreneur's willingness to include debt in the firm's capital structure.
B)the willingness of the entrepreneur to invest in his own project.
C)the entrepreneur's ability to attract private equity capital.
D)the entrepreneur's expressed willingness to remain as a manager of the firm.

Answer 3

the willingness of the entrepreneur to invest in his own project.

Question 4

As Akerlof argues, sellers who have a lemon, of course, know they have lemon but are not willing to tell the truth about the condition of their auto and, for the short selling period involved, can put their auto in a satisfactory condition that approximates the normal condition of the auto that are not lemons.In subsequent literature, this problem called the _______ problem.

A)informational asymmetry
B)agency
C)moral hazard
D)certification

Question 5

Akerlof also discusses the problem of ____in the health insurance market.Health insurers attempt to estimate, for each individual insurance applicant, the probability that they will file an insurance claim, and price insurance premiums accordingly.However, this is an imperfect process, so the insurer must offer a common premium to a specified group of individuals that reflects the average health of the individuals in the group, even though the individuals in the group differ in terms of their health and thus the probability of a claim.Each individual knows their own health better than the insurer, so those members of the group who are less healthy (and thus more likely to file a claim) will be more likely to purchase insurance policy, and thus the premium set by the insurer to reflect the average health of the entire group will be inadequate to compensate the insurer for the ex post sub-group of individuals that actually purchase a policy.

A)adverse selection
B)certification
C)moral hazard
D)informational asymmetry

Question 6

Which of the following was NOT mentioned by Akerlof to mitigate the lemons problem?

A)certification
B)using a costly signal
C)private negotiation
D)establishing a reputation
E)contract enforcement

Question 7

The leading piece of theoretical research in corporate finance is Myers and Majluf (1984).They showed that when there is information asymmetry between the market and managers, a pecking order emerges in terms of how the firm should obtain funds for capital investments.Specifically, a firm would prefer to use:

A)debt, then retained earnings, and finally outside equity.
B)retained earnings, then debt, and finally outside equity.
C)retained earnings, then outside equity, and finally debt.
D)debt, then outside equity, and finally retained earnings.