13) External financing by ________ should be more important in developing countries than in
industrialized countries because information about private firms is more difficult to collect in
developing countries.
A) financial intermediaries
B) bonds
C) stock
D) direct lending
14) That only large, well-established corporations have access to securities markets
A) explains why indirect finance is such an important source of external funds for businesses.
B) can be explained by the problem of moral hazard.
C) can be explained by government regulations that prohibit small firms from acquiring funds in
securities markets.
D) explains why newer and smaller corporations rely so heavily on the new issues market for
funds.
15) Because of the adverse selection problem
A) good credit risks are more likely to seek loans causing lenders to make a disproportionate
amount of loans to good credit risks.
B) lenders may refuse loans to individuals with high net worth, because of their greater proclivity
to “skip town.”
C) lenders are reluctant to make loans that are not secured by collateral.
D) lenders will write debt contracts that restrict certain activities of borrowers.
16) Net worth can perform a similar role to
A) diversification.
B) collateral.
C) intermediation.
D) economies of scale.
17) The problem of adverse selection helps to explain
A) why firms are more likely to obtain funds from banks and other financial intermediaries,
rather than from securities markets.
B) why collateral is an important feature of consumer, but not business, debt contracts.
C) why direct finance is more important than indirect finance as a source of business finance.
D) why lenders refuse loans to individuals with high net worth.
18) The concept of adverse selection helps to explain
A) why collateral is not a common feature of many debt contracts.
B) why large, well-established corporations find it so difficult to borrow funds in securities
markets.
C) why financial markets are among the most heavily regulated sectors of the economy.
D) why stocks are the most important source of external financing for businesses.
19) Tools to help solve the adverse selection problem in financial markets include all of the
following EXCEPT
A) diversification.
B) government regulations to increase information.
C) the use of financial intermediaries.
D) the private production and sale of information.
20) The statement “Only the people who don’t need money can borrow it!” can be explained by
the concept of
A) adverse selection.
B) moral hazard.
C) direct finance.
D) costly state verification.
21) How does collateral help to reduce the adverse selection problem in credit market?
15
Copyright © 2019 Pearson Education, Inc.
8.5 How Moral Hazard Affects the Choice Between Debt and Equity Contracts
1) Equity contracts
A) are claims to a share in the profits and assets of a business.
B) have the advantage over debt contracts of a lower costly state verification.
C) are used much more frequently to raise capital than are debt contracts.
D) are not subject to the moral hazard problem.
2) A problem for equity contracts is a particular type of ________ called the ________ problem.
A) adverse selection; principal-agent
B) moral hazard; principal-agent
C) adverse selection; free-rider
D) moral hazard; free-rider
3) 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.
A) principal-agent
B) adverse selection
C) free-rider
D) debt deflation
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.
A) principals; agents
B) principals; principals
C) agents; agents
D) agents; principals
5) The principal-agent problem
A) occurs when managers have more incentive to maximize profits than the stockholders-owners
do.
B) in financial markets helps to explain why equity is a relatively important source of finance for
American business.
C) would not arise if the owners of the firm had complete information about the activities of the
managers.
D) explains why direct finance is more important than indirect finance as a source of business
finance.
6) The principal-agent problem would not occur if ________ of a firm had complete information
about actions of the ________.
A) owners; customers
B) owners; managers
C) managers; customers
D) managers; owners
7) The recent Enron and Tyco International scandals are an example of
A) the free-rider problem.
B) the adverse selection problem.
C) the principal-agent problem.
D) the “lemons problem.”
8) The name economists give the process by which stockholders gather information by frequent
monitoring of the firm’s activities is
A) costly state verification.
B) the free-rider problem.
C) costly avoidance.
D) debt intermediation.
9) Because information is scarce
A) helps explain why equity contracts are used so much more frequently to raise capital than are
debt contracts.
B) monitoring managers gives rise to costly state verification.
C) government regulations, such as standard accounting principles, have no impact on problems
such as moral hazard.
D) developing nations do not rely heavily on banks for business financing.
10) Government regulations designed to reduce the moral hazard problem include
A) laws that force firms to adhere to standard accounting principles.
B) light sentences for those who commit the fraud of hiding and stealing profits.
C) state verification subsidies.
D) state licensing restrictions.
11) 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.
B) money market mutual fund.
C) pawn broker.
D) savings and loan association.
12) A venture capital firm protects its equity investment from moral hazard through which of the
following means?
A) It places people on the board of directors to better monitor the borrowing firm’s activities.
B) It writes contracts that prohibit the sale of an equity investment to the venture capital firm.
C) It prohibits the borrowing firm from replacing its management.
D) It requires a 50% stake in the company.
13) One way the venture capital firm avoids the free-rider problem is by
A) prohibiting the sale of equity in the firm to anyone except the venture capital firm.
B) prohibiting members from serving on the board of directors.
C) prohibiting the borrowing firm from replacing management.
D) requiring collateral equal to the value of the borrowed funds.
14) Equity contracts account for a small fraction of external funds raised by American businesses
because
A) costly state verification makes the equity contract less desirable than the debt contract.
B) of the reduced scope for moral hazard problems under equity contracts, as compared to debt
contracts.
C) equity contracts do not permit borrowing firms to raise additional funds by issuing debt.
D) there is no moral hazard problem when using a debt contract.
15) Debt contracts
A) are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals.
B) have a higher cost of state verification than equity contracts.
C) are used less frequently to raise capital than are equity contracts.
D) never result in a loss for the lender.
16) Since they require less monitoring of firms, ________ contracts are used more frequently
than ________ contracts to raise capital.
A) debt; equity
B) equity; debt
C) debt; loan
D) equity; stock
17) Solutions to the moral hazard in equity contracts include all of the following EXCEPT
A) government regulations to increase information.
B) the use of financial intermediaries.
C) the use of debt contracts.
D) government ownership of resources.
18) Explain the principal-agent problem as it pertains to equity contracts.
1) 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.
A) moral hazard
B) agency theory
C) diversification
D) the “lemons” problem
2) A debt contract is incentive compatible
A) if the borrower has the incentive to behave in the way that the lender expects and desires,
since doing otherwise jeopardizes the borrower’s net worth in the business.
B) if the borrower’s net worth is sufficiently low so that the lender’s risk of moral hazard is
significantly reduced.
C) if the debt contract is treated like an equity.
D) if the lender has the incentive to behave in the way that the borrower expects and desires.
3) High net worth helps to diminish the problem of moral hazard problem by
A) requiring the state to verify the debt contract.
B) collateralizing the debt contract.
C) making the debt contract incentive compatible.
D) giving the debt contract characteristics of equity contracts.
4) One way of describing the solution that high net worth provides to the moral hazard problem
is to say that it
A) collateralizes the debt contract.
B) makes the debt contract incentive compatible.
C) state verifies the debt contract.
D) removes all of the risk in the debt contract.
5) A clause in a debt contract requiring that the borrower purchase insurance against loss of the
asset financed with the loan is called a
A) collateral-insurance clause.
B) prescription covenant.
C) restrictive covenant.
D) proscription covenant.
6) Professional athletes often have contract clauses prohibiting risky activities such as skiing and
motorcycle riding. These clauses are
A) limited-liability clauses.
B) risk insurance.
C) restrictive covenants.
D) illegal.
7) For restrictive covenants to help reduce the moral hazard problem, they must be ________ by
the lender.
A) monitored and enforced
B) written in all capitals
C) easily changed
D) impossible to remove
8) Although restrictive covenants can potentially reduce moral hazard, a problem with restrictive
covenants is that
A) borrowers may find loopholes that make the covenants ineffective.
B) they are inexpensive to monitor and enforce.
C) too many resources may be devoted to monitoring and enforcing them, as debtholders
duplicate others’ monitoring and enforcement efforts.
D) they reduce the value of the debt contract.
9) Solutions to the moral hazard problem include
A) low net worth.
B) monitoring and enforcement of restrictive covenants.
C) greater reliance on equity contracts and less on debt contracts.
D) greater reliance on debt contracts than financial intermediaries.
10) A key finding of the economic analysis of financial structure is that
A) the existence of the free-rider problem for traded securities helps to explain why banks play a
predominant role in financing the activities of businesses.
B) while free-rider problems limit the extent to which securities markets finance some business
activities, nevertheless the majority of funds going to businesses are channeled through securities
markets.
C) given the great extent to which securities markets are regulated, free-rider problems are not of
significant economic consequence in these markets.
D) economists do not have a very good explanation for why securities markets are so heavily
regulated.
11) One possible reason for slower growth in developing and transition countries is
A) capital may not be directed to its most productive use.
B) strict accounting standards are too stringent for the banks to meet.
C) the weak link between government and financial intermediaries.
D) the lack of adverse selection and moral hazard problems.
12) One reason financial systems in developing and transition countries are underdeveloped is
A) they have weak links to their governments.
B) they make loans only to nonprofit entities.
C) the legal system may be poor making it difficult to enforce restrictive covenants.
D) the accounting standards are too stringent for the banks to meet.
13) Because of the weak systems of property rights in many developing and transition
economies, the financial system is unable to use collateral effectively worsening the ________
problem.
A) adverse selection
B) moral hazard
C) principal/agent
D) diversification
14) In developing countries, it can be expensive and time-consuming for the poor to legalize
their property ownership. Without legal title, the property cannot be used as ________ to borrow
funds.
A) collateral
B) points
C) interest
D) restrictive covenants
15) One reason China has been able to grow so rapidly even though its financial development is
still in its early stages is
A) the high savings rate of around 40%.
B) the shift of labor to the agricultural sector.
C) the stringent enforcement of financial contracts.
D) the ease of obtaining high-quality information about creditors.
16) The high growth rate in China in the last twenty years has similarities to the high growth rate
of ________ during the 1950s and 1960s.
A) the United States
B) the Soviet Union
C) Brazil
D) Mexico
17) In many developing and transition countries, commercial banks are owned by their
governments. These ________ may have little incentive to allocate their capital to the most
productive uses.
A) state-owned banks
B) central banks
C) national banks
D) federal banks
18) The primary loan customer of state-owned banks in developing and transition economies is
often
A) the government that owns the institutions.
B) the neediest businesses in the economy.
C) the start-up companies that will provide job growth.
D) outside corporations that see this as an opportunity to borrow at low rates.
19) Why does the free-rider problem occur in the debt market?