Question 1

The principal-agent problem
A)occurs when managers have more incentive to maximize profits than the stockholders-owners do.
B)in financial markets helps to explain why equity is a relatively important source of finance for American business.
C)would not arise if the owners of the firm had complete information about the activities of the managers.
D)explains why direct finance is more important than indirect finance as a source of business finance.

Accepted Answer

The principal-agent problem arises when there is a conflict of interest between the principal (owners or shareholders) and the agent (managers), often due to asymmetric information, where the agent has more information than the principal. If the owners had complete information about the managers' activities, this problem would not occur because they could perfectly monitor and ensure that managers act in the owners' best interests.

Question 2

Because information is scarce
A)helps explain why equity contracts are used so much more frequently to raise capital than are debt contracts.
B)monitoring managers gives rise to costly state verification.
C)government regulations,such as standard accounting principles,have no impact on problems such as moral hazard.
D)developing nations do not rely heavily on banks for business financing.

Accepted Answer

The answer of Because information is scarce
A)helps explain why equity...

Question 3

One way of describing the solution that high net worth provides to the moral hazard problem is to say that it
A)collateralizes the debt contract.
B)makes the debt contract incentive compatible.
C)state verifies the debt contract.
D)removes all of the risk in the debt contract.

Accepted Answer

High net worth provides a solution to the moral hazard problem by making the debt contract incentive compatible. This means that the borrower has a greater incentive to repay the debt because they have more at stake with their high net worth. Collateralizing the debt contract (A) can serve as an additional guarantee, but it does not necessarily address the moral hazard problem. State verifications of the debt contract (C) and removing all of the risk in the debt contract (D) do not provide a solution to the moral hazard problem either.

Question 4

High net worth helps to diminish the problem of moral hazard problem by
A)requiring the state to verify the debt contract.
B)collateralizing the debt contract.
C)making the debt contract incentive compatible.
D)giving the debt contract characteristics of equity contracts.

Accepted Answer

High net worth individuals are less likely to default on their debt contract because they have more to lose. This means that they have an incentive to behave in a way that is favorable for the lender. Therefore, making the debt contract incentive compatible helps to mitigate the moral hazard problem. A) and B) may also be effective solutions, but they do not necessarily address the root cause of the moral hazard problem. D) is not a relevant choice as it is not clear how debt contracts can be given equity-like characteristics.

Question 5

A debt contract is incentive compatible
A)if the borrower has the incentive to behave in the way that the lender expects and desires,since doing otherwise jeopardizes the borrower's net worth in the business.
B)if the borrower's net worth is sufficiently low so that the lender's risk of moral hazard is significantly reduced.
C)if the debt contract is treated like an equity.
D)if the lender has the incentive to behave in the way that the borrower expects and desires.

Accepted Answer

Incentive compatibility means that the borrower has the incentive to behave in the way that the lender expects and desires. This is achieved through aligning the borrower's incentives with the lender's expectations by linking the borrower's net worth to the performance of the business. If the borrower does not behave as expected, their net worth in the business will be jeopardized, providing a strong incentive for the borrower to act in the lender's best interest.

Question 6

The principal-agent problem would not occur if ________ of a firm had complete information about actions of the ________.
A)owners; customers
B)owners; managers
C)managers; customers
D)managers; owners

Accepted Answer

The principal-agent problem arises when there is a lack of alignment in the interests of principals (owners) and agents (managers), often exacerbated by information asymmetry. If owners had complete information about the actions of managers, this problem would not occur, as they could ensure that managers act in the owners' best interests.

Question 7

A clause in a debt contract requiring that the borrower purchase insurance against loss of the asset financed with the loan is called a
A)collateral-insurance clause.
B)prescription covenant.
C)restrictive covenant.
D)proscription covenant.

Accepted Answer

The answer of A clause in a debt contract requiring...

Question 8

Managers (________)may act in their own interest rather than in the interest of the stockholder-owners (________)because the managers have less incentive to maximize profits than the stockholder-owners do.
A)principals; agents
B)principals; principals
C)agents; agents
D)agents; principals

Accepted Answer

This is an example of the principal-agent problem, which occurs when one party (the principal, in this case the stockholder-owners) hires another party (the agent, in this case the managers) to act on their behalf, but the agent may have different goals or incentives than the principal. In this situation, the managers may prioritize their own interests, such as job security or prestige, over maximizing profits for the stockholder-owners.

Question 9

Equity contracts account for a small fraction of external funds raised by American businesses because
A)costly state verification makes the equity contract less desirable than the debt contract.
B)of the reduced scope for moral hazard problems under equity contracts,as compared to debt contracts.
C)equity contracts do not permit borrowing firms to raise additional funds by issuing debt.
D)there is no moral hazard problem when using a debt contract.

Accepted Answer

Costly state verification, which adds to the expense of equity contracts, makes them less desirable than debt contracts, which do not face the same level of verification costs.

Question 10

The name economists give the process by which stockholders gather information by frequent monitoring of the firm's activities is
A)costly state verification.
B)the free-rider problem.
C)costly avoidance.
D)debt intermediation.

Accepted Answer

The process described is costly state verification, which refers to the cost incurred by stockholders to obtain information about the firm's activities to ensure that management is acting in their best interest.

Question 11

One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal-agent problem is the
A)venture capital firm.
B)money market mutual fund.
C)pawn broker.
D)savings and loan association.

Accepted Answer

Venture capital firms typically provide funding to startup companies in exchange for equity in the company. This creates a situation where the venture capitalist has a stake in the success of the company, and therefore, is incentivized to closely monitor and oversee the actions of the company's management team, reducing the potential for moral hazard arising from the principal-agent problem.

Question 12

Although debt contracts require less monitoring than equity contracts,debt contracts are still subject to ________ since borrowers have an incentive to take on more risk than the lender would like.
A)moral hazard
B)agency theory
C)diversification
D)the "lemons" problem

Accepted Answer

Moral hazard refers to the situation where one party takes more risks with borrowed funds because they do not bear the full consequences of their actions. This is a common problem with debt contracts since the borrower expects to pay only interest and return the principal, regardless of the project's success.

Question 13

Explain the principal-agent problem as it pertains to equity contracts.

Accepted Answer

The answer of Explain the principal-agent problem as it pertains...

Question 14

Since they require less monitoring of firms,________ contracts are used more frequently than ________ contracts to raise capital.
A)debt; equity
B)equity; debt
C)debt; loan
D)equity; stock

Accepted Answer

Debt contracts, such as bonds, involve less monitoring of firms as the terms of the contract are typically more rigid and do not provide ownership in the company. On the other hand, equity contracts, such as stocks, require more monitoring as investors have ownership in the company and want to ensure that their investment is secure and profitable. Therefore, debt contracts are used more frequently than equity contracts to raise capital.

Question 15

Government regulations designed to reduce the moral hazard problem include
A)laws that force firms to adhere to standard accounting principles.
B)light sentences for those who commit the fraud of hiding and stealing profits.
C)state verification subsidies.
D)state licensing restrictions.

Accepted Answer

Laws that force firms to adhere to standard accounting principles help to reduce the moral hazard problem because they require transparency and accurate reporting of financial information. This reduces the ability of managers or owners to hide profits or engage in other unethical behavior that would harm stakeholders or the public. The other options (B, C, and D) do not directly address the moral hazard problem and may even exacerbate it by reducing accountability or competition.

Question 16

Debt contracts
A)are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals.
B)have a higher cost of state verification than equity contracts.
C)are used less frequently to raise capital than are equity contracts.
D)never result in a loss for the lender.

Accepted Answer

Debt contracts are agreements by the borrower to pay the lenders fixed dollar amounts at periodic intervals. Option B is incorrect as debt contracts have a lower cost of state verification than equity contracts. Option C is also incorrect as debt contracts are actually more commonly used to raise capital than equity contracts. Option D is incorrect as debt contracts can result in losses for lenders, particularly in cases of default by the borrower.

Question 17

The recent Enron and Tyco scandals are an example of
A)the free-rider problem.
B)the adverse selection problem.
C)the principal-agent problem.
D)the "lemons problem."

Accepted Answer

Enron and Tyco scandals are a classic example of the principal-agent problem, where the agents (i.e., corporate executives) deviate from the interests of the principals (i.e., shareholders) to benefit themselves personally. In both scenarios, executives concealed information, inflated earnings, and engaged in fraudulent practices to manipulate the stock prices in their favor.

Question 18

Professional athletes often have contract clauses prohibiting risky activities such as skiing and motorcycle riding.These clauses are
A)limited-liability clauses.
B)risk insurance.
C)restrictive covenants.
D)illegal.

Accepted Answer

The contract clauses prohibiting risky activities are known as restrictive covenants. These are provisions in a contract that limit or prohibit an individual from engaging in certain activities. The purpose of these clauses is to protect the interests of the employer, in this case, the team, by ensuring that their players do not engage in activities that could result in injury or harm. These clauses are legal and enforceable as long as they are reasonable in scope and duration.

Question 19

One way the venture capital firm avoids the free-rider problem is by
A)prohibiting the sale of equity in the firm to anyone except the venture capital firm.
B)prohibiting members from serving on the board of directors.
C)prohibiting the borrowing firm from replacing management.
D)requiring collateral equal to the value of the borrowed funds.

Accepted Answer

The free-rider problem in venture capital is mitigated by restricting the sale of equity to anyone except the venture capital firm itself. This ensures that the venture capital firm retains control and benefits directly from its investments and efforts in improving the company, preventing others from benefiting without contributing.

Question 20

A venture capital firm protects its equity investment from moral hazard through which of the following means?
A)It places people on the board of directors to better monitor the borrowing firm's activities.
B)It writes contracts that prohibit the sale of an equity investment to the venture capital firm.
C)It prohibits the borrowing firm from replacing its management.
D)It requires a 50% stake in the company.

Accepted Answer

By placing people on the board of directors, a venture capital firm can better monitor the borrowing firm's activities and ensure that there is no moral hazard. The other options listed may also be used by a venture capital firm, but they do not directly address the issue of moral hazard.

Quiz 8: An Economic Analysis of Financial Structure

The principal-agent problem

Because information is scarce

One way of describing the solution that high net worth provides to the moral hazard problem is to say that it

High net worth helps to diminish the problem of moral hazard problem by

A debt contract is incentive compatible

The principal-agent problem would not occur if of a firm had complete information about actions of the .

A clause in a debt contract requiring that the borrower purchase insurance against loss of the asset financed with the loan is called a

Managers () may act in their own interest rather than in the interest of the stockholder-owners () because the managers have less incentive to maximize profits than the stockholder-owners do.

Equity contracts account for a small fraction of external funds raised by American businesses because

The name economists give the process by which stockholders gather information by frequent monitoring of the firm's activities is

One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal-agent problem is the

Although debt contracts require less monitoring than equity contracts,debt contracts are still subject to ________ since borrowers have an incentive to take on more risk than the lender would like.

Explain the principal-agent problem as it pertains to equity contracts.

Since they require less monitoring of firms, contracts are used more frequently than contracts to raise capital.

Government regulations designed to reduce the moral hazard problem include

Debt contracts

The recent Enron and Tyco scandals are an example of

Professional athletes often have contract clauses prohibiting risky activities such as skiing and motorcycle riding.These clauses are

One way the venture capital firm avoids the free-rider problem is by

A venture capital firm protects its equity investment from moral hazard through which of the following means?

Quiz 8: An Economic Analysis of Financial Structure

The principal-agent problem

Because information is scarce

One way of describing the solution that high net worth provides to the moral hazard problem is to say that it

High net worth helps to diminish the problem of moral hazard problem by

A debt contract is incentive compatible

The principal-agent problem would not occur if ________ of a firm had complete information about actions of the ________.

A clause in a debt contract requiring that the borrower purchase insurance against loss of the asset financed with the loan is called a

Managers (________) may act in their own interest rather than in the interest of the stockholder-owners (________) because the managers have less incentive to maximize profits than the stockholder-owners do.

Equity contracts account for a small fraction of external funds raised by American businesses because

The name economists give the process by which stockholders gather information by frequent monitoring of the firm's activities is

One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal-agent problem is the

Although debt contracts require less monitoring than equity contracts,debt contracts are still subject to ________ since borrowers have an incentive to take on more risk than the lender would like.

Explain the principal-agent problem as it pertains to equity contracts.

Since they require less monitoring of firms,________ contracts are used more frequently than ________ contracts to raise capital.

Government regulations designed to reduce the moral hazard problem include

Debt contracts

The recent Enron and Tyco scandals are an example of

Professional athletes often have contract clauses prohibiting risky activities such as skiing and motorcycle riding.These clauses are

One way the venture capital firm avoids the free-rider problem is by

A venture capital firm protects its equity investment from moral hazard through which of the following means?

The principal-agent problem would not occur if of a firm had complete information about actions of the .

Managers () may act in their own interest rather than in the interest of the stockholder-owners () because the managers have less incentive to maximize profits than the stockholder-owners do.

Since they require less monitoring of firms, contracts are used more frequently than contracts to raise capital.