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Moral Hazard, Liquidity and Costly Investment

Student: Guseva Yuliya

Supervisor: Vladimir Busygin

Faculty: Faculty of Economic Sciences

Educational Programme: Master

Year of Graduation: 2014

<div>This paper is devoted to a moral hazard problem in project and firm financing. The classical&nbsp;</div><div>&nbsp;</div><div>agent-principal problem assumes that the principal has a task, which can be done by the agent.&nbsp;</div><div>&nbsp;</div><div>The success of this task depends on how much costly effort was exerted by the agent, so the&nbsp;</div><div>&nbsp;</div><div>principal gives compensation for the agent to cover these costs. &nbsp;The moral hazard problem&nbsp;</div><div>&nbsp;</div><div>arises when the principal cannot observe actions of the agent. &nbsp;However, he can observe another&nbsp;</div><div>&nbsp;</div><div>variable that is only an imperfect signal of the agent&rsquo;s effort. In case of financial contracts such&nbsp;</div><div>&nbsp;</div><div>signal is performance of the project, for example, profit, share in the market or growth. The&nbsp;</div><div>&nbsp;</div><div>principal object is to maximize his own income, so he proposes a contract to motivate the agent&nbsp;</div><div>&nbsp;</div><div>to work harder. The contract specifies the compensation for the agent conditional on the&nbsp;</div><div>&nbsp;</div><div>observable variable that is imperfectly correlated with the agent&rsquo;s actions.&nbsp;</div><div>&nbsp;</div><div>In this paper we tried to compare classical model with the modified model, which is designed to&nbsp;</div><div>&nbsp;</div><div>follow the problem of moral hazard in project and firm financing. The classic model does not fit&nbsp;</div><div>&nbsp;</div><div>perfectly the problem of venture financing since the agent is penniless and receives&nbsp;</div><div>&nbsp;</div><div>compensation only after the realization of the project. However, venture firms often deal with&nbsp;</div><div>&nbsp;</div><div>significant amount of funds invested in the beginning of the project lifecycle. To adapt the&nbsp;</div><div>&nbsp;</div><div>classic model the compensation for the agent was divided into two parts. First part, as in the&nbsp;</div><div>&nbsp;</div><div>classic model, is received after the realization on profits depending on the project performance.&nbsp;</div><div>&nbsp;</div><div>The second part is considered as initial investment that is specified in the contract and is received&nbsp;</div><div>&nbsp;</div><div>before the project starts. It is also considered that the financing of the project and the chosen&nbsp;</div><div>&nbsp;</div><div>level of effort should be aligned. Scarce investment makes even high effort inefficient, while&nbsp;</div><div>&nbsp;</div><div>excess financing induces the agent to steal a part of funds. While this additional initial&nbsp;</div><div>&nbsp;</div><div>investment makes the modified model closer to the real world project financing simulation it also&nbsp;</div><div>&nbsp;</div><div>makes the model less efficient comparing to the classic one. The allocation of initial financing is&nbsp;</div><div>&nbsp;</div><div>an additional source of information rent, which should be paid by the investor. Therefore, in case&nbsp;</div><div>&nbsp;</div><div>the investor has all bargaining power, the overall effort and project value becomes less in the&nbsp;</div><div>&nbsp;</div><div>modified model. However, the shift of bargaining power to the agent makes her exert higher&nbsp;</div><div>&nbsp;</div><div>effort and increase efficiency. The only drawback is that this approach decreases the investor&rsquo;s&nbsp;</div><div>&nbsp;</div><div>return of capital, which is, however, a familiar effect of rising efficiency on financial markets.&nbsp;</div><div>&nbsp;</div><div>The case when all the bargaining power belongs to the agent corresponds with perfectly&nbsp;</div><div>&nbsp;</div><div>competitive financial markets. Therefore, the real life project values lay somewhere in between&nbsp;</div><div>&nbsp;</div><div>the two extreme cases: all bargaining power on the entrepreneur&rsquo;s side and all bargaining power&nbsp;</div><div>&nbsp;</div><div>on the investor&rsquo;s side.</div>

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