Fixed cost, Financing and Limited Liability

Financing and Uncertainty The necessity of fixed cost often raises the question of financing. Sometimes financing cannot be repaid. This raises the question of liability. All estimation at the beginning of projects contains uncertainty. How uncertainty affects decision making processes for producers and financiers?

Parental investments and children’s obligations Parental investment is universal in life Parental investments are very high in human societies. Offspring’s obligations to their old age parents and their younger siblings are more in some societies, than others. How to understand these differences?

In a society with low offspring obligations, they have more freedom to pursue their own interests, which provides more opportunity for economic growth. Societies with low family liability often have high social liability in the form of taxes. Old age security is socialized from tax revenues.

Some other impacts of low family responsibility However, many people may take a free ride. They may opt not to have children but still enjoy socialized senior care. People will also have less ability to raise many children because their children are less likely to share family responsibility

In a society with high offspring obligation, they may have less opportunity to pursue their own ideas and interests. Less innovative activities, which limit the potential for economic growth. But parents will have more incentives and abilities to raise more children

Evaluate the tradeoff Whether fertility is over or below replacement rate. In other words, whether or not biological return is positive. If fertility is below replacement rate, current level of economic activities cannot be sustained.

Resource abundance, financing liability and economic growth In a society with abundant resource, limited liability will encourage activities that turn resources into products. This will stimulate economic growth. In a society with scarce resource, unlimited liability will discourage waste of resources. This will make the society more sustainable.

Financing cycles: In life and in firms When you are young, you are mainly financed by equity from your parents. If you are five years old, try go to a bank and tell a loan officer: “I am going to be a billionaire in twenty years. I would like to get a million dollar loan today.” Similarly, young firms that have not yet generated steady earnings are mainly financed with equity.

For people with steady and growing income, they may be able to obtain loans easily, especially loans mortgaged with tangible assets such as houses. For firms with steady and growing income, they may be able to obtain loans easily, especially loans secured with tangible assets.

When people mature in age, they may raise children and support others. When firms mature, they distribute dividends.

Example A person has an opportunity to undertake two projects Project one: –Initial investment: one thousand dollars –Payoff: 50% chance 1,500 dollar,50% chance 1,000 dollars after one year Project two –Initial investment: one million dollars –Payoff: 50% chance 1,500,000 dollar,50% chance 1,000,000 dollars after one year.

Example (Continued) The person has one thousand dollar capital. The loan interest rate is 10% per year. We assume the cost of capital is equal to the loan interest rate. If the liability is unlimited, which means the debtors could be imprisoned or have to work as slaves, which project you would choose? If the liability is limited, which project you would choose? Please calculate net present values of project one and two from social perspective and owner’s perspective

Calculations Both projects are bank financed. Social perspective NPV of project one (1500*50%+1000*50%)/ = NPV of project two ( *50% *50%)/ =

Notes If a project is self financed, the operator’s perspective is the same as the social perspective.

Owner’s perspective in limited liability environment with external financing Project one (1500/ )*50%= Project two ( / )*50%= Are values from the social perspective and the owner’s perspective same?

Discussion In a limited liability environment, project value from social perspective is never higher than project value from owner’s perspective. The difference is ultimately subsidized by the society. The cause of financial crisis Why we still support limited liability system?

Unlimited liability system In a unlimited liability system, the person is most likely choose project one, which can be self financed with his own money. This results in the choice of low NPV project.

Conclusion By supporting limited liability system and taxing profitable projects, whole society could benefit. Limited liability system stimulate economic growth. Potential downside of limited liability system?

Example A person has an opportunity to undertake two projects Project one: –Initial investment: one thousand dollars –Payoff: 50% chance 1,500 dollar,50% chance 1,000 dollars Project two –Initial investment: one million dollars –Payoff: 50% chance 1,500,000 dollar,50% chance 300,000 dollars

Example (Continued) The person has one thousand dollar capital. The loan interest rate is 10%. If the liability is unlimited, which means the debtors could be imprisoned or have to work as slaves, which project you would choose? If the liability is limited, which project you would choose? Please calculate net present values of project one and two from social perspective and owner’s perspective

Calculations We assume the cost of capital is the loan interest rate. Social perspective, or owner’s perspective with self financing NPV of project one (1500*50%+1000*50%)/ = NPV of project two ( *50% *50%)/ =

Owner’s perspective in limited liability environment Assume both projects are financed externally. Project one (1500/ )*50%= Project two ( / )*50%= Are values from the social perspective and the owner’s perspective same?

Some observation Value from social perspective is very negative while from owner’s perspective is very positive. Moral hazard How to weigh the tradeoff between more potential for economic growth and moral hazard?

Discussion When the growth potential is high, we are willing to invest more in risky projects and are more willing to bear the downside risk. Consequently, we are more tolerant to moral hazard as long as the policy generate high economic growth overall.

Discussion (continued) What ultimately determines the growth potential? The interactions between technology and resources Technology increase resource base. It also consumes more resources. Most highly developed civilizations eventually turn into desolate places. How the attitude on limited liability and risk taking will evolve in the future?

Level of uncertainty and project choices

Example A person has an opportunity to undertake two projects Project one: –Initial investment: one million dollars –Payoff: 50% chance 1,800,000 dollar,50% chance 600,000 dollars after one year Project two –Initial investment: one million dollars –Payoff: 50% chance 1,500,000 dollar,50% chance 1,000,000 dollars after one year.

Example (Continued) Assume the lender cannot detect the differences in earning structures of two projects and charge the same loan rate at 10% per year. Please calculate net present values of project one and two from social perspective and owner’s perspective Which project you would choose?

Calculations Social perspective, or owner’s perspective with self financing NPV of project one ( *50% *50%)/ = NPV of project two ( *50% *50%)/ =

Calculation Owner’s perspective with external financing Project one ( / )*50%= Project two ( / )*50%= NPV from the first project is higher. How level of uncertainty affects project choices in limited liability environment? Why banks suffer such huge losses in the financial crisis?

Method of financing and human behavior We often demand the best health care for our aging parents. If the cost of health care comes out of our own pockets, we might act differently. When we call certain thing, such as education, a “right”, it means that we think it should be financed publicly. Public financing is more equal. At the same time, it generates a lot of waste.

Financing of Fixed cost Some high fixed cost projects are self financed However, many projects require billions of dollar initial capital –Oil sand projects –Mining projects –Pipelines External financing

Methods of external financing Debt financing and equity financing –Debt financing: fixed interest payment, higher fixed cost, maintaining more control, more risky –Equity financing: dividend distribution more flexible, lower fixed cost, maintaining less control, less risky

Debt financing –Public debt: Issuing cost as fixed cost, generally lower interest payment, more information release –Bank financing: No issuing cost, generally higher interest payment, less information release Tradeoffs between bank financing and public debt –If the size of debt issuing is large, which method you would prefer?

Research shows that in places with high growth potential, such as USA, equity financing is more popular while in places with less growth potential, such as Europe, debt financing is more popular. In places with high growth potential, laws favor more equity holders than debt holders while in places with less growth potential, it is the opposite. Chapter 11 in US allow equity holders to stop interest payment for a period of time while in continental Europe, laws are more concerned about the residual values for debt holders.

Causality and correlation In many researches, correlations are explained as causalities. For example, relation between limited liability and wellbeing of society Why the global financial crisis originated in US?

Forms of Business Ownership Sole Proprietorships Limited Liability Partnership Corporations Advantages and disadvantages of each types of ownership The order of complexity of different forms of ownership