Question

In: Finance

Solutions to the moral hazard problem include

 

Question 1

Solutions to the moral hazard problem include

a. high net worth.

b. monitoring and enforcement of restrictive covenants.

c. greater reliance on equity contracts and less on debt contracts.

d. all of the above.

e. only A and B of the above.

Question 2

Debt contracts

a. are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals.

b. have an advantage over equity contracts in that they have a lower cost of state verification.

c. are used much more frequently to raise capital than equity contracts.

d. all of the above.

e. only A and B of the above.

Question 3

The analysis of asymmetric information predicts that the ________ a corporation is, the more likely it will be to ________.

a. smaller and less well known; issue securities

b. larger and more well known; borrow from financial intermediaries

c. larger and more well known; issue securities

d. smaller and less well known; need external financing

Solutions

Expert Solution

1. Solution to major hazard problem includes e (A&B)

A.High netwoth makes the debt contract incentive compatible and thus it helps to minimize the hazard problems. It prevents more dependence on debt.

B.  monitoring and enforcement of restrictive covenants. this means monitoring and controlling the covenants i,e terms and conditions of the contract that we have agreed. This helps to overcome the problems that we may incur by lack of proper monitoring

Reasons for C is incorrect

Greater reliance on equity contract than the debt contract is not the solution because both are eually important based on the structure of the entity. SO relying on one of them is not correct.

2. Debt contracts satisfies all the following conditions so answer is d. all the above

a. are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals.

b. have an advantage over equity contracts in that they have a lower cost of state verification.

c.  are used much more frequently to raise capital than equity contracts. Because of low cost.

3. asymmetric information means lack of availability of information to outsiders or the third parties. This people will have better information about the large business rather than the small business, eventhough the risk and rewards of the small business is eually good as large business. so this asymmetric information predicts that due to lack of availability of proper information only the large and well known the corporation is, the more likely it will be to issue securities.

so the answer is C

Because the smaller and less known firm it would be difficult to issue securities because the investors dont have knowledge about the business.

Borrowing from external financing can be done by both small and large business so this is not related to asymentric information. Because the lender will be able to provide the loan for both.


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