![The monitor’s stake Rm can be chosen equal to
C
/(P) and the monitor’s investment
contribution equal to
…….. [using (5) and (6)]
The monitoring cost is small enough that
monitoring increases the pledgeable income:](https://image.slidesharecdn.com/monitoringintheinvestmentdecision-250727064921-7842c03b/85/Monitoring-in-the-investment-Decision-ppt-for-business-students-11-320.jpg)
![Rm denote the monitor’s payoff in the case of
success, the monitor chooses his monitoring
intensity so as to maximize
[xPH + (1x) PL] Rm c(x)
So, (p) Rm = C (x) -------(13)
Comparing (12) and (13) yields](https://image.slidesharecdn.com/monitoringintheinvestmentdecision-250727064921-7842c03b/85/Monitoring-in-the-investment-Decision-ppt-for-business-students-16-320.jpg)
Monitoring in the investment Decision.ppt for business students
- 2. Benefits of Activism Fixed Investment Model + A Monitor who can Intervene In order to reduce the scope for moral hazard * A risk neutral entrepreneur with wealth A has a project costing I>A and must borrow: I-A (from investors)
- 3. The project yields R when it succeeds and 0 when it fails. • The probability of success is PH if the entrepreneur works and PL = PH - P if she shirks
- 4. No Monitoring Shirking Provides private benefit ‘B’(In absence of monitoring) Rb = Entrepreneur’s reward incase of success Entrepreneur receives nothing in case of failure as she is protected by limited liability (LL) Incentive compatibility requires (P) Rb B --------- (1) Funding requirements Pledgeable income > Investor’s investment i.e., Entrepreneur’s (borrower’s) utility is: Ub = PHR I ---------------- (3) i.e. the project’s NPV.
- 5. Monitoring (with Fixed Intensity) Monitoring reduces the extent of moral hazard. That reduce the private benefit enjoyed by the entrepreneur by shirking from B to b < B. Monitor bear unobservable private monitoring cost- C > 0 in order to achieve the reduction in private benefit.
- 6. Three projects: a) the ‘good project’ which yields no private benefit and has a probability of success ‘PH’; b) The low-private-benefit ‘bad project’ that yields private benefit ‘b’ and has probability of success ‘PL’; and c) The high-private-benefit ‘Bad Project’ which yields private benefit ‘B’ and has probability of success ‘PL’.
- 7. Suppose that the entrepreneur ‘hires a monitor and that the monitor’s incentive induce him to monitor. Let, b = Entrepreneur’s private benefit from shirking. Rb = Rewards incase of success. So, the entrepreneur works if and only if (P) Rb b --------- (4) Let, (P) Rb < B; If Rb B /P , the entrepreneur is induced to work even in the absence of monitoring. So, monitoring is useless.
- 8. The monitor receives a reward ‘Rm’ in case of success, and ‘0’ in case of failure (because of LL). The monitor is unable to prevent the entrepreneur from shirking if the monitor does incurring cost ‘C’. Thus incentive for monitoring is provided by an Rm so that (P) Rm C --------- (5)
- 9. Abundance of Monitoring Capital Assumption Monitoring capital is abundant or not scarce. There is a large supply of monitors who are willing to invest their capital in the monitoring activity. The firm’s investment at level Im such that PHRm C = Im ……………. (6) No rent for monitor Receives net payment PHRm Im = C
- 10. Non monitoring or uniformed investors are willing to fund the project if and only if PH (R Rb Rm) I A Im ………. (7) Using (4), (5) and (6), the necessary and sufficient condition for the project to be funded is Monitoring reduces the agency cost from PH B /P to PH b /P but adds monitoring cost ‘C’
- 11. The monitor’s stake Rm can be chosen equal to C /(P) and the monitor’s investment contribution equal to …….. [using (5) and (6)] The monitoring cost is small enough that monitoring increases the pledgeable income:
- 12. When does the entrepreneur benefit from having a monitor? The entrepreneur’s utility is equal to the project’s NPV under monitoring: Ub = PHR I C …………. (10) The NPV is positive even in the presence of monitoring: PHR>I + C Monitoring reduces the entrepreneur’s utility by monitoring cost and so the entrepreneur forgoes monitoring if she can obtain funding in its absence.
- 13. No funding Monitoring No Monitoring A Ā A A = I + C PH (R b/p) Ā = I PH (R B/p) Entrepreneur’s with strong balance sheets (e.g., with A Ā) borrowing cheaply because they can do without monitoring. Entrepreneurs with weaker balance sheets (A A Ā) borrow expensively.
- 14. Variable Monitoring : Intensity Model Fixed Investment Model with uncertainty about the outcome of monitoring The monitor discovers the Bad Project (Private Benefit B) with probability x, and nothing with probability 1 x. The probability x of effective monitoring depends on the unverifiable effort cost or disutility of effort C (x) incurred by the large monitor. Disutility of effort is increasing (C> 0) and convex (C> 0) and that C(0) = 0, and C(1) = .
- 15. Let, Borrower’s reward, Rb, in case of success is smaller than B /P i.e. Rb< B/P and larger than b /P (thus effective monitoring prevents shirking). Borrower’s utility Ub = x PH R + (1x) PL RI C(x) …….. (11) The level X* of monitoring that maximizes the NPV is then given by (P)R B = C(x* ) ……….. (12) At this level of monitoring, there is enough pledge able income to pay back the investors:
- 16. Rm denote the monitor’s payoff in the case of success, the monitor chooses his monitoring intensity so as to maximize [xPH + (1x) PL] Rm c(x) So, (p) Rm = C (x) -------(13) Comparing (12) and (13) yields
- 17. In the absence of monitoring, the borrower is unable to borrow. So Rb is strictly smaller than B /P. So, Rm< R Rb …………… (15) In words, the monitor should not hold all external shares in the firm.
- 18. Scarce Monitoring Capital Absence of monitoring capital Assume the potential monitors have no capital So the monitor cannot contribute to the initial investment. Since Im = 0, the monitor enjoys rent This decreases both the borrower's utility and the amount of income that can be pledged to the uninformed investors. Borrower’s utility and the project’s NPV: (PHR I C)
- 19. The pledgeable income exceed the uninformed investor’s initial outlay becomes Implications are the same as in the case of abundant monitoring capital.
- 20. General Case Assume that monitoring capital has a shadow cost. That is, the monetary return ‘X’ on the monitor’s investment contribution, defined by is intermediate between its value, PH/PL, when monitoring capital is abundant and the infinite level that obtains when monitors have no capital. The monitor enjoys rent M given by The borrower’s utility is lower than the NPV and equal to Ub = PHR I C M (X>PH/PL) Similarly, the financing condition becomes:
- 21. Other Costs Associated with Monitoring Monitoring cost = C. C exceeds the mere disutility of effort C(x) There are several reasons (besides scarcity of monitoring capital):- Lack of diversification Illiquidity Collusion
- 22. Thank You