29) Private information-collection firms fail to eliminate the adverse selection problem because
A) the law does not allow them to disclose private information about the creditworthiness of
firms.
B) they do not monitor borrowers after loans have been made.
C) some investors who do not pay for their services will still profit from them.
D) most companies refuse to provide them with any information.
30) The free-rider problem faced by private information-collection firms results in their
A) usually going out of business within a few years.
B) collecting less than all the available information about the firms they investigate.
C) being plagued by lawsuits.
D) charging fees higher than can be justified by market conditions.
31) A firm’s net worth is equal to the value of its
A) assets minus the value of its liabilities.
B) liabilities minus the value of its assets.
C) common stock minus the value of its outstanding bonds.
D) outstanding bonds minus the value of its common stock.
32) Lenders prefer to lend to firms with high net worth because
A) such firms are usually willing to pay higher interest rates.
B) the owners of such firms have more to lose if the firm defaults on a loan.
C) the government requires most bank loans to be made to such firms.
D) such firms usually are unable to raise funds directly through financial markets.
33) Moral hazard arises from
A) the difficulty of distinguishing good-risk borrowers from bad-risk borrowers.
B) the likelihood that bad-risk borrowers are more likely to accept a loan than are good-risk
borrowers.
C) savers’ difficulties in monitoring borrowers.
D) borrowers’ difficulties in locating savers.
34) Moral hazard problems arise when
A) lenders have difficulty in distinguishing between good and lemon firms.
B) when a downturn in economic activity makes repaying loans difficult for borrowers.
C) borrowers have an incentive to act in ways that do not reflect the lender’s interests.
D) borrowers default on loans.
35) Moral hazard problems arise when
A) lenders have difficulty in distinguishing between good and lemon firms.
B) when a downturn in economic activity makes repaying loans difficult for borrowers.
C) borrowers default on loans.
D) borrowers have an incentive to conceal information.
36) Acme Widget tells investors it wants to build a new widget factory and sell investors
$10,000,000 in bonds to finance it. Once they have raised the $10,000,000 the owners of Acme
Widget use the funds to finance a trip to Atlantic City to try out a new scheme they have devised
to win at blackjack. This is an example of
A) the adverse selection problem in financial markets.
B) the moral hazard problem in financial markets.
C) the difficulty lenders have in distinguishing good from lemon firms.
D) the problems with using rational expectations in financial markets.
37) Suppose one person buys a copy of Consumer Reports and gives away free copies to all who
request one. This is an example of
A) free rider problem.
B) moral hazard.
C) adverse selection.
D) economies of scale.
38) Suppose some members of Enron’s board of directors are aware of the company’s true
financial condition, information that is not available to most investors. This is an example of
A) lemon problem.
B) moral hazard.
C) adverse selection.
D) asymmetric information.
39) Which of the following agencies has established standardized accounting principles for
reporting corporate earnings?
A) The Securities and Exchange Commission
B) The Federal Trade Commission
C) The National Accounting Board
D) The Fair Reporting Commission
40) A firm’s principals are its
A) shareholders.
B) management.
C) values.
D) customers.
41) A firm’s agents are its
A) shareholders.
B) management.
C) marketing department.
D) customers.
42) When managers do not own very much of the net worth of the firm, then
A) there may be a principal-agent problem.
B) the firm will usually have to raise most of its funds in financial markets.
C) the firm will have to rely more on equity financing than debt financing.
D) the firm will have to rely more on debt financing than equity financing.
43) In the United States the stake of top management in firms’ ownership usually is
A) less than 5%.
B) more than 25%.
C) more than 50%.
D) more than 75%.
44) With debt financing
A) moral hazard problems are eliminated.
B) moral hazard problems are reduced but not eliminated.
C) adverse selection problems are eliminated.
D) firms reduce the risk that they will become bankrupt during a recession.
45) Moral hazard is not eliminated in debt financing because
A) borrowers have an incentive to assume greater risk than is in the interest of the lender.
B) firms with a great deal of debt often go bankrupt.
C) principal-agent problems are greater with debt financing than with equity financing.
D) the use of restrictive covenants tends to increase moral hazard.
46) Restrictive covenants
A) generally require that firms use debt finance rather than equity finance.
B) generally require that firms use equity finance rather than debt finance.
C) put restrictions on the use of borrowed funds.
D) were outlawed under the Civil Rights Act of 1964.
47) Which of the following is NOT true of restrictive covenants?
A) They sometimes require borrowers to maintain the value of collateral offered to the lender.
B) They increase the marketability and liquidity of loans.
C) They sometimes require a borrower to maintain a certain minimum level of net worth.
D) They sometimes limit a borrower’s risk taking.
48) Banks deal with problems of adverse selection by
A) charging high interest rates.
B) gathering information about the default risk of borrowers.
C) making only short-term loans.
D) making only long-term loans.
49) In effect, banks are able to charge
A) depositors for banks’ superior information about borrowers.
B) borrowers for banks’ superior information about depositors.
C) the government for banks’ superior information about borrowers and depositors.
D) interest rates that are in fact above those legally allowed.
50) The main reason why banks are the leading source of external finance for businesses is
A) the interest rates on bank loans are usually lower than interest rates on corporate bonds.
B) banks have an information-cost advantage in reducing adverse selection problems.
C) interest paid on bank loans is deductible against the corporate income tax, whereas interest
paid on corporate bonds is not.
D) government regulators encourage small businesses to obtain funding from banks.
51) Venture capital firms attempt to overcome the principal-agent problem by
A) investing only in industries with high profit rates.
B) charging high interest rates on loans.
C) holding large equity stakes in the firms they invest in.
D) avoiding investing in common stock.
52) Financial intermediaries are able to act as delegated monitors for individual savers because
A) other investors are unable to gain a free ride on their monitoring efforts.
B) borrowers consider this role to be traditional for financial intermediaries and are willing to put
up with it.
C) the federal government has granted them waivers from laws protecting privacy.
D) they employ a vast network of private detectives to carry out their monitoring role.
53) Banks require collateral for loans in order to
A) ensure that borrowers have significant amounts of their own funds invested in their
businesses.
B) charge higher interest rates on loans.
C) reduce their tax liability on the interest they collect on loans.
D) reduce the total amount they are obliged to lend to any one borrower.
54) The use of collateral
A) allows banks to charge higher interest rates on loans.
B) makes it more costly for borrowers to take advantage of their asymmetric information.
C) makes it more costly for lenders to take advantage of their asymmetric information.
D) has important tax implications for both borrowers and lenders.
55) All of the following are benefits of securitization EXCEPT
A) risk sharing.
B) reduced interest rates that borrowers pay on loans.
C) increased liquidity.
D) fewer adverse selection problems.
56) How is the lemons problem in the used car market an example of asymmetric information?
57) How does adverse selection affect the economic efficiency of the used car market?
58) How do car dealers help reduce adverse selection?
59) How does adverse selection affect the willingness of corporations to issue stock?
60) How does adverse selection affect the participation of small- and medium-sized firms in the
stock market?
61) How do high interest rates increase the risk of adverse selection in the bond market?
62) How does adverse selection in financial markets affect the method by which firms raise
funds?
63) What are the reasons why disclosure by the SEC do not eliminate the information costs of
adverse selection?
64) How does the use of collateral and net worth help reduce the problem of adverse selection?
65) How does the principal-agent problem increase the possibility of moral hazard?
66) How can restrictive covenants help to reduce moral hazard in bond markets?
9.3 Conclusions About the Structure of the U.S. Financial System
1) In the late 2000s, which of the following was the primary source of external financing for
small to medium-size firms?
A) mortgages
B) bank loans other than mortgages
C) trade credit
D) other loans
2) In the late 2000s, the primary source of external funds for corporations was
A) commercial paper.
B) loans.
C) bonds.
D) stocks.
3) In the late 2000s, which source of funds for corporations grew the most?
A) net new stock issues
B) net new bond issues
C) net new loans
D) net new commercial paper
4) Smaller firms tend to rely on financial intermediaries instead of financial markets for external
financing due to
A) transactions costs.
B) adverse selection.
C) moral hazard.
D) all of the above.
5) Why are corporations more likely to raise funds externally by debt instead of equity?
A) moral hazard is less of a problem with debt contracts
B) transactions costs tend to be higher in the stock market than bond market
C) to avoid paying dividends
D) interest rates tend to be lower than dividend rates
6) Which of the following is the most important source of external financing for corporations?
A) stock market
B) bond market
C) retained earnings
D) mortgages
7) The purpose of collateral and restrictive covenants is to reduce ___ in debt contracts.
A) adverse selection
B) transactions costs
C) moral hazard
D) loan amounts
8) By reducing transactions and information costs, financial intermediaries can
A) offer savers higher interest rates.
B) offer borrowers lower interest rates.
C) earn a profit.
D) all of the above.
9) A market maker
A) brings together buyers and sellers of a financial asset.
B) ensures all information is available to buyers and sellers.
C) disclose to the seller the intentions of the buyer.
D) disclose to the buyer the intentions of the seller.
10) When information costs of securities are very high, they lack
A) collateral.
B) transparency.
C) transactions costs.
D) creditworthiness.
11) What are the three key features of the financial system that result from the existence of
transactions and information costs?