Question 1

Solutions to the moral hazard in equity contracts include all of the following EXCEPT

Accepted Answer

Government ownership of resources is not a solution to the moral hazard in equity contracts as it completely eliminates the principle-agent problem, and also eliminates the incentive for the agent to work hard and create value. Instead, solutions that reduce the information asymmetry between the principal and agent, such as government regulations to increase information or the use of financial intermediaries to monitor and enforce contracts, or solutions that align the interests of the principal and agent, such as the use of debt contracts, are preferable.

Question 2

A debt contract is incentive compatible

Accepted Answer

A debt contract is incentive compatible when it aligns the incentives of the borrower with those of the lender, so that the borrower has the incentive to behave in a way that benefits the lender's interest. This is achieved by designing the contract such that if the borrower deviates from the expected behavior, it would harm their net worth in the business. In other words, the borrower has to face consequences for their actions, which ensures that they will follow the terms of the contract.

Question 3

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 4

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

The scenario described is an example of agency theory, in which agents (managers) may prioritize their own interests over those of the principals (stockholder-owners) due to differing incentives. Therefore, the answer is D, as it correctly identifies managers as agents and stockholder-owners as principals.

Question 5

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 6

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 7

Because information is scarce

Accepted Answer

The answer of Because information is scarce
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Question 8

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

Accepted Answer

Costly state verification is a major disadvantage of equity contracts as compared to debt contracts, as it makes the equity contract less desirable. This is why businesses primarily rely on debt rather than equity to raise external funds.

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

Accepted Answer

The name for the process by which stockholders gather information by frequent monitoring of the firm's activities is called costly state verification. This is because it is costly for stockholders to gather information and verify that the firm is taking actions that align with their best interests.

Question 11

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 transparency and accountability. This makes it more difficult for firms to hide their true financial situation and engage in risky behavior without consequences. Light sentences for fraud or subsidies for verification may not be as effective in preventing moral hazard. State licensing restrictions may also not be enough by themselves as firms may still engage in risky behavior if they know they are guaranteed a bailout.

Question 12

The recent Enron and Tyco scandals are an example of

Accepted Answer

The Enron and Tyco scandals are an example of the principal-agent problem because executives of these companies, acting as agents, pursued their own interests instead of aligning them with the interests of the company's owners, or principals. This led to unethical and illegal behavior, which ultimately harmed the company and its stakeholders.

Question 13

Moral hazard in equity contracts is known as the ________ problem because the manager of the firm has fewer incentives to maximize profits than the stockholders might ideally prefer.

Accepted Answer

Principal-agent problem refers to the situation where the agent (manager) of a firm has different goals than the principal (stockholders) and may act in ways that benefit themselves at the expense of the principal. This is also known as moral hazard, as the manager may take on more risk than optimal due to the incomplete alignment of their incentives with those of the stockholders.

Question 14

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 typically invest their own money in startups and closely monitor the businesses they invest in, often taking an active role in their management. This creates a stronger alignment of interests between the principal (investors) and the agent (entrepreneur), reducing the likelihood of the agent engaging in morally hazardous behavior to the detriment of the principal. Money market mutual funds also act as intermediaries, but they are not necessarily designed to mitigate the principal-agent problem in the same way as venture capital firms. Pawnbrokers and savings and loan associations are not financial intermediaries that typically address the principal-agent problem in any significant way.

Question 15

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 management is acting in the best interest of the company and its investors. This helps prevent moral hazard, as the borrowing firm is less likely to engage in risky or fraudulent behavior if it knows that its actions are being closely scrutinized. The other options do not directly address the issue of moral hazard.

Question 16

Debt contracts

Accepted Answer

Debt contracts are agreements by borrowers to pay lenders fixed dollar amounts at periodic intervals, such as monthly or annually. This payment includes both principal and interest. Therefore, option A is correct. Option B is incorrect because equity contracts have a higher cost of state verification as compared to debt contracts. Option C is also incorrect because, in reality, debt contracts are used more frequently to raise capital than equity contracts due to the lower risk associated with them. Option D is incorrect because there is always a risk of default or non-payment by the borrower in debt contracts, which can result in a loss for the lender.

Question 17

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 the borrower will take on excessive risk or engage in risky behavior knowing that the lender bears the losses. This can occur even with debt contracts because the borrower may still have an incentive to take on more risk than the lender would find desirable. Therefore, debt contracts are still subject to moral hazard. The other answer choices (B, C, and D) are not directly relevant to the question of borrower risk-taking behavior with debt contracts.

Question 18

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

Accepted Answer

Debt contracts typically have less stringent monitoring requirements, as the lender has priority in receiving repayment and can typically impose covenants on the borrower to ensure timely payments. Equity contracts, on the other hand, involve ownership in the company and require ongoing monitoring to ensure that the company is being managed in the best interest of shareholders. Therefore, debt contracts are typically used more frequently than equity contracts to raise capital, particularly for smaller or less established companies.

Question 19

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 provides a solution to the moral hazard problem by making the debt contract incentive compatible. When a borrower has a high net worth, they have more to lose if they default on the debt contract. This gives them an incentive to fulfill their duties under the contract and reduces the moral hazard problem.

Question 20

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

Accepted Answer

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

Quiz 8: An Economic Analysis of Financial Structure

Solutions to the moral hazard in equity contracts include all of the following EXCEPT

A debt contract is incentive compatible

The principal-agent problem

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.

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

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

Because information is scarce

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

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

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

Government regulations designed to reduce the moral hazard problem include

The recent Enron and Tyco scandals are an example of

Moral hazard in equity contracts is known as the ________ problem because the manager of the firm has fewer incentives to maximize profits than the stockholders might ideally prefer.

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 protects its equity investment from moral hazard through which of the following means?

Debt contracts

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.

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

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

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

Quiz 8: An Economic Analysis of Financial Structure

Solutions to the moral hazard in equity contracts include all of the following EXCEPT

A debt contract is incentive compatible

The principal-agent problem

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.

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

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

Because information is scarce

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

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

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

Government regulations designed to reduce the moral hazard problem include

The recent Enron and Tyco scandals are an example of

Moral hazard in equity contracts is known as the ________ problem because the manager of the firm has fewer incentives to maximize profits than the stockholders might ideally prefer.

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 protects its equity investment from moral hazard through which of the following means?

Debt contracts

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.

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

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

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

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.