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Cash Flows

Cash Flows

Consider a firm where the effort undertaken by managers can affect cash flows inthe next period. For simplicity, assume managers either exert low effort or higheffort. Assume that investors cannot observe effort.

a) Assume that, with low effort, the firm realizes XL with certainty and, withhigh effort, the firm realizes XH with certainty. If cash flows can beobserved by investors, is there asymmetric information between
investors and managers Explain.
b) Now assume that, with low effort, the firm earns XL with probability qand XH with probability (1- q). With high effort, the firm realizes XL withprobability p and XH with probability (1- p). If q > p, is there asymmetricinformation between investors and managers If so, is it hidden
information or hidden action Explain.
c) Assume that in bankruptcy, the managers are dismissed without
collecting bonuses. Assume no taxes or costs of bankruptcy. Would higherlevels of debt raise the value of the firm Explain.


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