Question 1

Explain the four tools that can help solve the principal-agent problem.

Accepted Answer

The answer of Explain the four tools that can help...

Question 2

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

Accepted Answer

High net worth individuals have greater financial resources and are less likely to default on their debts. This reduces the moral hazard problem by making the debtor less likely to shirk responsibility and/or engage in risky behavior that could harm the lender. In this way, high net worth helps to make the debt contract incentive compatible, minimizing the risk of moral hazard.

Question 3

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

Accepted Answer

The contract clauses prohibiting risky activities such as skiing and motorcycle riding are called restrictive covenants. These are often included in contracts to protect the athlete's health and prevent injuries that could potentially prevent them from performing and fulfilling their obligations under the contract.

Question 4

Government regulations designed to reduce the moral hazard problem include ________.

Accepted Answer

Laws that force firms to adhere to standard accounting principles help reduce the moral hazard problem by increasing the transparency and accuracy of financial information, making it more difficult for firms to hide risky behavior or mislead investors. Light sentences for fraud and theft would actually worsen the moral hazard problem by reducing the consequences for engaging in such behavior. State verification subsidies and licensing restrictions may not be directly related to addressing the moral hazard problem.

Question 5

The Enron and Tyco scandals are an example of ________.

Accepted Answer

Enron and Tyco scandals are classic examples of the principal-agent problem where the agents (Enron and Tyco executives) acted in their own interest rather than the shareholders (principals) by manipulating financial statements and engaging in fraudulent activities.

Question 6

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 risk that a borrower will take on riskier projects or investments because they are not bearing the full cost of the potential losses. This can lead to the borrower defaulting on their debt obligations or taking actions that negatively affect the lender's interests. Therefore, even though debt contracts require less monitoring than equity contracts, lenders still need to consider the risk of moral hazard and take steps to mitigate it in order to protect their investment.

Question 7

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 individuals provide a solution to the moral hazard problem by making the debt contract incentive compatible. This means that they align their interests with the debtor by agreeing to take on more risk in exchange for receiving higher returns. This provides an incentive for the debtor to act in the best interest of the creditor and to not take unnecessary risks, as it would negatively impact the creditor's investment. Collateralizing the debt contract, state verification, or removing all risk would not necessarily address the moral hazard problem specifically.

Question 8

Venture capital firms have been important in developing the ________ sector in Canada.

Accepted Answer

Venture capital firms are known for investing in high-risk, high-reward startups, and Canada's venture capital industry has been particularly active in funding and developing the high-tech sector. This has helped create a thriving startup ecosystem, particularly in cities like Toronto, Montreal, and Vancouver. While venture capital firms may invest in other sectors, the high-tech sector has been a priority in Canada.

Question 9

Equity contracts account for a small fraction of external funds raised by Canadian businesses because ________.

Accepted Answer

Costly state verification is a major deterrent for businesses to choose equity contracts over debt contracts. In equity contracts, investors become part owners of the firm and have a claim over its profits, but verifying the firm's true profitability is difficult and expensive for the state. This increases the risk for investors and reduces the attractiveness of equity contracts as a funding option for businesses.

Question 10

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

Accepted Answer

Debt contracts generally require less monitoring of firms because they involve the repayment of a fixed amount of money with interest over a specified period of time. Equity contracts, on the other hand, involve ownership stakes in the firm and require more monitoring because shareholders have the right to vote on important company decisions and receive a portion of profits.

Question 11

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 12

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 start-up businesses and often take an active role in managing and guiding the company. They provide capital in exchange for ownership in the company and are incentivized to ensure the company succeeds. This reduces the moral hazard from the principal-agent problem as the venture capitalists have a vested interest in ensuring the success of the company and are actively involved in its operations. Money market mutual funds and savings and loan associations do not necessarily address the principal-agent problem, and pawn brokers are not typically considered financial intermediaries.

Question 13

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 better monitor the borrowing firm's activities and ensure that the management is acting in the best interests of the company and its stakeholders. This helps to mitigate the risk of moral hazard, where the management may act in their own self-interest at the expense of the company and its shareholders. The other choices may also help to protect the venture capital firm's investment, but they do not specifically address the issue of moral hazard.

Question 14

Because information is scarce ________.

Accepted Answer

The answer of Because information is scarce ________.
...

Question 15

Which of the following is not one of the four types of restrictive covenants?

Accepted Answer

Restrictive covenants typically include covenants to discourage undesirable behavior, encourage desirable behavior, and keep collateral valuable. "Covenants for incentive compatibility" is not a standard category of restrictive covenants.

Question 16

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

Accepted Answer

Costly state verification is the process by which stockholders gather information by frequent monitoring of the firm's activities. This is done in order to ensure that the managers are acting in the best interest of the shareholders. It is referred to as "costly" because it requires resources to be allocated to gather information, which can be costly for shareholders. The other options (B, C, D) are not related to this process.

Question 17

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 18

A debt contract is incentive compatible ________.

Accepted Answer

A debt contract is incentive compatible 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. This aligns the interests of both the borrower and the lender and reduces the risk of moral hazard. Option B is incorrect because having a low net worth does not automatically imply that the borrower will behave in a way that is desirable for the lender. Option C is incorrect because treating a debt contract like an equity would result in a different set of incentives and risks. Option D is incorrect because it is the borrower who needs to have the incentive to behave as expected, not the lender.

Question 19

Debt contracts ________.

Accepted Answer

Debt contracts are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals, such as interest payments and principal repayments. Hence, option A is the correct answer. Option B is incorrect because it is the equity contracts that have a higher cost of state verification. Option C is also incorrect because debt contracts are a commonly-used method to raise capital. Lastly, option D is incorrect because debt contracts do carry a risk of loss for the lender, such as if the borrower defaults on payments.

Question 20

For restrictive covenants to help reduce the moral hazard problem they must be ________ by the lender.

Accepted Answer

Restrictive covenants can only help reduce the moral hazard problem if they are monitored and enforced by the lender. This ensures that the borrower is held accountable for complying with the agreement and reduces the likelihood of them engaging in risky behavior.

Quiz 8: An Economic Analysis of Financial Structure