Asymmetric information: work it out 1 a private equity firm is considering whether to take over another firm, called the "target." the target has several projects in the pipeline so no one is certain exactly what the target is worth but estimates are that it is worth anywhere between 0 and 100, with each value equally likely. although the value of the target is uncertain, the private equity firm knows that the target is currently ill managed and that in their hands they could increase the target's value by 50%, that is, multiply the target's value by a factor of . if the firm is currently worth 60, for example, it would be worth 60 x 3 90 after new management is installed. a. find a mutually profitable price for this acquisition, that is, a price such that, on average or in expectation, the owners of both the target and the private equity firm expect to profit. it to know that, when any outcome between a and b is equally likely, the expected or average outcome is a b-a what is the lowest price the target's owners are willing to accept for the firm? minimum price (target): s what is the highest price the equity firm is willing to pay for the target firm? maximum price (equity firm): s asymmetric information: work it out 3 a private equity firm is considering whether to take over another firm, called the "target." the target has several projects in the pipeline so no one is certain exactly what the target is worth but estimates are that it is worth anywhere between 0 and 100, with each value equally likely. although the value of the target is uncertain, the private equity firm knows that the target is currently ill managed and that in their hands they could increase the target's value by 50%, that is, multiply the target's value by a factor of 큭. if the firm is currently worth 60, for example, it would be worth 60 × 90 after new management is installed. b. now assume that the current owners of the target know whether the projects in the pipeline are going well or not and so they know the current value of the firm. only the outsider buyer, the private equity firm, is uncertain about the value of the target, which they continue to estimate is worth between 0 and 100, with each value equally likely. until the target is bought, information about its true value cannot be credibly communicated to the potential buyer. naturally, the current owners will sell only if the private equity firm offers them at least as much or more than the current value. notice that we have transformed a problem of uncertain but symmetric information into a problem of asymmetric information recall from part a that when neither firm had any information, any price between $50 and $75 was mutually profitable. is this range of prices still mutually profitable now that the target firm knows its own value? the previous range of prices will still be mutually profitable, and more prices will be as well. the target firm's owners will only accept an offer if the target firm has a relatively high value. since the equity firm knows that any accepted offer will result in it buying a high-value firm, its maximum acceptable price will increase the previous range of prices will still be mutually profitable, and more prices will be as well. there is an adverse selection problem here-the target firm's owners will only accept an offer if the target firm has a relatively low value. acceptable price will increase. the mutually profitable range of prices will not change. whether or not the target firm's owners know, the value of their own firm ahead of time does not change their minimum acceptable price as calculated in part a. the previous range of prices will no longer be mutually profitable. there is an adverse selection problem here-the target firm's owners will only accept an offer if the target firm has a relatively low value. since the equity firm knows that any accepted offer will result in it buying a low-value firm, its maximum acceptable price will decrease. c. which of the following statements accurately comments on the effect of asymmetric information on trade? asymmetric information poses no greater impediment to trade than symmetric but uncertain information. uncertainty changes the terms of trade, but all deals that are mutually beneficial should be realized in situations of asymmetric information. asymmetric information makes trade more difficult; transactions that are mutually beneficial break down due to one party knowing more than the other. oasymmetric information makes trader easier, trade agreements have a higher probability of success due to the signals parties send to one another.