Question 1

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

Accepted Answer

Costly state verification makes equity contracts less desirable than debt contracts, as the verification costs associated with equity contracts are higher due to the monitoring required by shareholders. This results in a higher cost of issuing equity and can discourage firms from using equity contracts to raise funds.

Question 2

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

Accepted Answer

Venture capital firms are known to invest in high-risk, high-reward start-up companies which are usually in the technology sector. Thus, they have played an important role in developing the high tech sector in Canada.

Question 3

Because information is scarce ________.

Accepted Answer

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

Question 4

A debt contract is incentive compatible ________.

Accepted Answer

Incentive compatibility refers to the situation where both parties have an incentive to behave in a way that benefits the other party. In this case, if the borrower has an incentive to behave in a way that the lender expects, then they are more likely to do so since their net worth is tied up in the business. This reduces the lender's risk of moral hazard, making the debt contract incentive compatible.

Question 5

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 to ensure that the borrower complies with the terms and conditions of the covenant. If the lender does not enforce the covenant, the borrower may be tempted to take actions that increase the risk for the lender, leading to a higher probability of default. Therefore, monitoring and enforcing the restrictive covenants is essential. None of the other options are necessary for reducing the moral hazard problem.

Question 6

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 7

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

Accepted Answer

Contract clauses prohibiting risky activities such as skiing and motorcycle riding are known as restrictive covenants. These clauses are included to protect the investment made in the athlete's abilities by the team or organization.

Question 8

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 9

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

Accepted Answer

Debt contracts usually have more specific terms and require less monitoring of firms compared to equity contracts. Therefore, debt contracts are used more frequently than equity contracts to raise capital.

Question 10

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 idea that borrowers may not act in the best interest of the lender once they have obtained the loan. They may take on more risk than the lender would like, leading to potential defaults on the loan. This is why even debt contracts require some level of monitoring. Agency theory refers to the relationship between the lender and borrower, which is not relevant to this question. Diversification and the "lemons" problem are also not relevant to this question.

Question 11

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 12

Debt contracts ________.

Accepted Answer

Debt contracts are agreements between borrowers and lenders in which the borrower agrees to pay the lender fixed dollar amounts at periodic intervals, including interest payments. Option B is incorrect because equity contracts have a higher cost of state verification than debt contracts. Option C is incorrect because debt contracts are often used to raise capital, especially in the bond market. Option D is incorrect because lenders can still face losses if borrowers default on their debt obligations.

Question 13

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 refers to the process by which stockholders gather information by frequent monitoring of the firm's activities. This is because it can be costly for stockholders to gather accurate and relevant information about a company's activities, and they must constantly monitor the firm to ensure that their investment is worthwhile. The other options listed are not related to this process.

Question 14

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 the borrower has an incentive to act in the best interest of the lender because they have a lot to lose if they were to default on the loan. The high net worth individual is essentially putting their own wealth at risk by lending money, which encourages the borrower to take the loan more seriously and repay it on time. This improves the overall integrity of the debt contract and reduces the risk of moral hazard. Collateralizing the debt contract (choice A) is one way of addressing the issue, but it doesn't necessarily solve the moral hazard problem completely. The state verifying the debt contract (choice C) may offer some additional protection, but it's not the primary solution. Removing all the risk in the debt contract (choice D) is not possible and would not address the root cause of the moral hazard problem.

Question 15

The recent Enron and Tyco scandals are an example of ________.

Accepted Answer

The Enron and Tyco scandals are examples of the principal-agent problem, where the interests of the agent (usually management) are not aligned with those of the principal (usually shareholders or stakeholders). In both cases, management made decisions that benefited themselves at the expense of the company and its shareholders.

Question 16

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 prevent moral hazard. This allows them to have direct access to information about the company's operations and decision-making processes, which reduces the likelihood of the borrower engaging in risky behavior that could harm the venture capital firm's investment. The other options do not directly address the issue of moral hazard.

Question 17

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

Accepted Answer

Laws that force firms to adhere to standard accounting principles provide transparency and accuracy in financial reporting. This reduces the moral hazard problem by making it more difficult for firms to hide their true financial conditions, which in turn reduces the likelihood of risky behavior due to a false sense of security. Light sentences for fraud and state licensing restrictions do little to address the moral hazard problem, while state verification subsidies are not a common regulation used to address the issue.

Question 18

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 19

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 20

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 in start-up companies or early-stage businesses, providing funding and guidance to help them grow and become profitable. In doing so, they become more involved in the management and decision-making processes of the firms they invest in, reducing the principal-agent problem that leads to moral hazard.

Quiz 8: An Economic Analysis of Financial Structure