Question 1

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

Accepted Answer

Venture capital firms invest in startup companies and provide funding in exchange for a share of ownership. They have a keen interest in ensuring that the company's management team is competent and makes sound decisions since the success of the company will determine their return on investment. Thus, they actively monitor the company's decisions and provide guidance and advice to the management team, reducing the principal-agent problem and moral hazard. The other options, such as money market mutual funds, pawnbrokers, and savings and loan associations, may not be directly involved in monitoring the principal-agent problem and may not have as much influence over the management team's decision-making.

Question 2

A debt contract is incentive compatible

Accepted Answer

A debt contract is incentive compatible if it aligns the interests of the borrower and lender such that the borrower has an incentive to behave in the way that the lender expects and desires. This is achieved by structuring the contract such that default or other undesirable behavior by the borrower would jeopardize their net worth in the business.

Question 3

Because information is scarce

Accepted Answer

The answer of Because information is scarce
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Question 4

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

Accepted Answer

By placing people on the board of directors, the venture capital firm can closely monitor the borrowing firm's activities and ensure that their investment is not being misused due to moral hazard. This allows them to keep an eye on the management and decision-making processes of the borrowing firm to ensure that their investment is safe. Writing contracts to prohibit the sale of an equity investment, prohibiting the borrowing firm from replacing its management, or requiring a 50% stake in the company are not direct measures to protect against moral hazard.

Question 5

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.

Accepted Answer

Moral hazard refers to the tendency of borrowers to take on more risk than agreed upon in the debt contract, since they are not taking on the full risk of the investment. This means that debt contracts are still subject to monitoring and enforcement to ensure that borrowers do not engage in behavior that puts the lender at risk.

Question 6

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 7

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

Accepted Answer

High net worth reduces the moral hazard problem by making the debt contract incentive compatible. This means that the borrower has a personal interest in fulfilling their obligations, as defaulting on the loan would result in significant financial losses. This reduces their incentive to behave in a way that jeopardizes the loan, decreasing the likelihood of moral hazard. Verification of the debt contract (A) and collateralization (B) may also help to reduce the moral hazard problem, but they do not specifically address the issue of incentive compatibility. Giving the debt contract characteristics of equity contracts (D) may increase the borrower's incentive to perform well, but would not necessarily reduce the moral hazard problem.

Question 8

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

Accepted Answer

High net worth serves as a form of collateral for the debt contract but more importantly, it aligns the interests of the borrower and the lender by making the borrower financially liable for the success or failure of the investment project. This makes the debt contract incentive compatible, reducing the moral hazard problem. The state does not play a role in verifying the debt contract nor does high net worth remove all risk from the debt contract.

Question 9

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

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 10

The recent Enron and Tyco scandals are an example of

Accepted Answer

The Enron and Tyco scandals were primarily caused by the principal-agent problem, where the executives of these companies prioritized their personal gains over the interests of the shareholders they were supposed to represent. This resulted in fraudulent accounting practices and misrepresentations of the company's financial health, ultimately leading to their downfall. The free-rider problem, adverse selection problem, and lemons problem are not directly related to these scandals.

Question 11

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

Accepted Answer

The process described in the question is known as costly state verification, which refers to the cost that shareholders incur to monitor the activities of the firm to ensure that management is acting in their best interests. This monitoring is necessary because shareholders do not have direct control over the management of the firm. The other choices listed do not accurately describe this process.

Question 12

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

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 13

The principal-agent problem

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 14

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

Accepted Answer

Costly state verification makes equity contracts less desirable than debt contracts as the verification costs associated with equity contracts are high. Therefore, businesses prefer to use debt contracts instead of equity contracts to raise external funds.

Question 15

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

Accepted Answer

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

Question 16

Debt contracts

Accepted Answer

Debt contracts are agreements where the borrower agrees to pay fixed dollar amounts to the lender at regular intervals. This is in contrast to equity contracts where the issuer does not have a fixed obligation to make payments to investors. Option B is incorrect as debt contracts have a lower cost of state verification compared to equity contracts. Option C is also incorrect as debt contracts are used more frequently to raise capital than equity contracts. Option D is incorrect as there is a possibility of loss to the lender in case the borrower defaults on the payment.

Question 17

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

Accepted Answer

The clauses prohibiting risky activities in professional athlete contracts are known as restrictive covenants. These clauses limit the athlete's behavior outside of their profession to protect against injuries or other negative consequences that could impact their performance or team.

Question 18

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.

Accepted Answer

This is an example of the principal-agent problem, where the principals (stockholder-owners) hire agents (managers) to act on their behalf, but the agents may have their own interests that do not align with those of the principals. Therefore, the managers (agents) may not maximize profits in the same way that the stockholder-owners (principals) would, as they have less incentive to do so.

Question 19

Government regulations designed to reduce the moral hazard problem include

Accepted Answer

Laws that force firms to adhere to standard accounting principles make it more difficult for firms to manipulate financial statements in a way that hides losses or risks, reducing the likelihood of a moral hazard problem. The other options (B, C, and D) do not address or reduce the moral hazard problem.

Question 20

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

Accepted Answer

Debt contracts typically require less monitoring of firms than equity contracts do. Debt contracts are a form of borrowing where a fixed amount of money is borrowed and agreed to be repaid with interest over time, while equity contracts involve selling a portion of ownership in the company to investors. As a result, debt contracts are often preferred by firms because they require fewer disclosures and monitoring of their business operations by investors.

Quiz 8: An Economic Analysis of Financial Structure