One principal-agent conflict is that between a firm's creditors (as a principal) and its shareholders (as agent).For example, after issuing risky debt, stockholders have an incentive to increase the riskiness of the firm's assets (e.g., by changing operating strategy), which would tend to expropriate wealth from creditors to stockholders.Which of the assumptions of an ideal capital market is violated in this example?
A)Capital Markets are frictionless
B)Homogeneous expectations
C)Atomistic competition
D)The firm has a fixed investment program
E)Once chosen, the firm's financing is fixed

Question

Quizplus · Accepted Answer

EThe conflict described violates the assumption that the firm has a fixed investment program (D) because shareholders might change the firm's operating strategy to increase risk after issuing debt. It also violates the assumption that once chosen, the firm's financing is fixed (E) because the change in strategy can affect the firm's risk profile and thus its financing conditions.

One Principal-Agent Conflict Is That Between a Firm's Creditors (As