Question 1

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 2

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 agency theory, where managers are agents and stockholder-owners are principals. The managers may be more concerned with their own personal gain, such as job security or maximizing their own compensation, rather than maximizing profits for the stockholder-owners. The stockholder-owners, on the other hand, have a greater incentive to maximize profits as it directly impacts their return on investment.

Question 3

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

Accepted Answer

Costly state verification (i.e. the need for expensive audits and monitoring) makes equity contracts less desirable than debt contracts for external funding, as equity investors have greater incentives to shirk their responsibilities and take advantage of firm managers. Debt contracts, on the other hand, offer more stringent covenants and monitoring mechanisms that can reduce the likelihood of moral hazard problems. Additionally, equity contracts do not prohibit borrowing firms from issuing debt, so option C is incorrect. Option D is also incorrect, as there are moral hazard problems inherent in any financial contract between investors and firms.

Question 4

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

Accepted Answer

The process of stockholders gathering information by frequently monitoring the activities of the firm is referred to as costly state verification. This verification is necessary to ensure that the firm is using its resources and funds appropriately, and it can be costly for the stockholders to continuously gather this information.

Question 5

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 6

Debt contracts

Accepted Answer

Debt contracts are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals. This makes them different from equity contracts, which represent ownership in the company and do not require fixed payments to investors. Option B is incorrect because debt contracts have a lower cost of state verification than equity contracts. Option C is incorrect because debt contracts are actually used more frequently to raise capital than equity contracts. Option D is incorrect because there is always a risk of default on a debt contract, which could result in a loss for the lender.

Question 7

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 provide funding to start-up companies in exchange for ownership in the company. They typically take an active role in the management of the company and provide expertise to help ensure the success of the investment. By doing so, they align the interests of the principal (the investor) with those of the agent (the entrepreneur), reducing the moral hazard problem. Money market mutual funds and savings and loan associations also act as financial intermediaries, but they do not necessarily have the same active involvement in the management of the companies they invest in. Pawn brokers are not typically considered financial intermediaries in the same sense as the other options provided.

Question 8

A debt contract is incentive compatible

Accepted Answer

A debt contract is incentive compatible when the borrower has the incentive to behave in the way that the lender expects and desires because the borrower's net worth is at stake. If the borrower behaves in a way that jeopardizes their net worth, they may face penalties such as higher interest rates or even foreclosure, which would result in a loss of assets for the borrower. Thus, the borrower has a strong incentive to comply with the terms of the debt contract, making it incentive compatible.

Question 9

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 10

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 11

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 activities of the borrowing firm and ensure that they are using the funds in accordance with the agreed-upon terms. This helps to mitigate moral hazard, which is the risk that the borrowing firm may act in their own self-interest and not in the best interest of the venture capital firm. The other options may offer some level of protection, but they do not directly address the issue of moral hazard.

Question 12

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 promoting transparency and accuracy in financial reporting, reducing the ability of firms to hide risky or fraudulent behavior. Options B, C, and D do not directly address the moral hazard problem.

Question 13

Because information is scarce

Accepted Answer

The answer of Because information is scarce
...

Question 14

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 15

The recent Enron and Tyco scandals are an example of

Accepted Answer

The Enron and Tyco scandals are perfect examples of the principal-agent problem. The agents (top executives) were acting against the interests of the principals (shareholders) and engaging in fraudulent activities for personal gain. This misalignment of incentives and lack of proper monitoring led to the collapse of both companies.

Question 16

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 additional risk because they do not bear the full cost of their actions, which is a problem that lenders face in debt contracts as well. This can lead to borrowers defaulting on their debt obligations if their risky actions lead to financial distress.

Question 17

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 acts as a form of collateral in the debt contract, making it more likely that the borrower will fulfill their obligations. By providing a significant amount of their own assets as collateral, the borrower has more at stake in the success of the venture, reducing the likelihood of risky behavior. This makes the debt contract incentive compatible, as both parties have aligned interests in the success of the venture. However, it does not remove all of the risk in the debt contract, as there is always a chance that the venture will not succeed, leading to default. The state does not necessarily verify the debt contract, as it is a private agreement between two parties.

Question 18

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

Accepted Answer

These clauses are known as restrictive covenants, as they restrict the athlete from engaging in certain activities that could potentially impact their ability to perform and fulfill their contractual obligations. They are a common feature in sports contracts and are intended to protect the interests of the team or organization.

Question 19

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 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 compared to equity contracts, as lenders are primarily concerned with receiving their scheduled interest and principal payments. As a result, debt contracts are used more frequently than equity contracts to raise capital.

Quiz 8: An Economic Analysis of Financial Structure

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

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

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

Debt contracts

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

A debt contract is incentive compatible

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

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

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

Government regulations designed to reduce the moral hazard problem include

Because information is scarce

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

The recent Enron and Tyco scandals are an example of

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.

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

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

The principal-agent problem

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

Quiz 8: An Economic Analysis of Financial Structure

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

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

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

Debt contracts

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

A debt contract is incentive compatible

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

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

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

Government regulations designed to reduce the moral hazard problem include

Because information is scarce

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

The recent Enron and Tyco scandals are an example of

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.

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

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

The principal-agent problem

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

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.

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

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