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Question 1

What is the most important source of external financing for businesses?

Answer 1

Financial intermediaries (like banks), not stocks or bonds

Question 2

Do businesses primarily finance operations by issuing debt and equity securities?

Answer 2

No, issuing marketable securities (like stocks and bonds) is not the primary method of financing operations.

Question 3

Which is more important: direct finance or indirect finance?

Answer 3

Indirect finance (through financial intermediaries) is many times more important than direct finance (through stocks or bonds).

Question 4

How regulated is the financial system?

Answer 4

The financial system is one of the most heavily regulated sectors of the economy.

Question 5

What is the most important source of external funds for businesses?

Answer 5

Banks and other financial intermediaries are the most important sources of external funding

Question 6

Who has easy access to securities markets to finance their activities?

Answer 6

Only large, well-established corporations have easy access to securities markets.

Question 6

What is collateral in a debt contract?

Answer 6

Collateral is property pledged to a lender to guarantee repayment of a loan.

Question 7

What is the difference between secured and unsecured debt?

Answer 7

Secured debt: Backed by collateral (e.g., mortgage).

Unsecured debt: No collateral (e.g., credit card debt).

Question 8

Why are debt contracts highly complex?

Answer 8

Debt contracts are long and detailed legal documents with restrictive covenants to regulate borrower activities.

Question 9

Why do financial intermediaries exist?

Answer 9

To reduce transaction costs and provide efficient services for borrowing and lending.

Question 10

How do financial intermediaries reduce transaction costs?

Answer 10

Economies of scale: Pool large funds to reduce per dollar cost.

Expertise: Provide financial advice and services.

Liquidity services: Make transactions easier (e.g., money market funds).

Question 11

Why do transaction costs affect direct finance?

Answer 11

High brokerage fees and large denominations of stocks/bonds make it costly for individuals to participate in direct finance.

Question 12

What is asymmetric information?

Answer 12

It occurs when one party (borrower) has more information than the other (lender), creating risk in lending.

Question 13

Why do banks exist in the presence of asymmetric information?

Answer 13

Banks reduce asymmetric information by:

Screening borrowers before lending.

Monitoring borrower activities after lending.

Question 14

How do financial intermediaries protect themselves from asymmetric information?

Answer 14

Require collateral.

Include restrictive covenants in loan agreements.

Perform credit checks.

Question 15

Why do small businesses rely heavily on banks?

Answer 15

Small businesses lack access to securities markets and rely on bank loans for funding.

Question 16

What is the role of economies of scale in finance?

Answer 16

It allows financial intermediaries to bundle funds, reducing per-unit transaction costs.

Question 17

Why is the financial system heavily regulated?

Answer 17

protect consumers
reduce risk
prevent financial crises.

Question 18

What are the two problems caused by asymmetric information?

Answer 18

Adverse selection (before the transaction)

Moral hazard (after the transaction)

Question 19

What is adverse selection?

Answer 19

Adverse selection occurs before the transaction when:

Riskier borrowers are more likely to apply for loans.

Lenders may unknowingly give loans to high-risk borrowers.

Question 20

What is moral hazard?

Answer 20

Moral hazard occurs after the transaction when:

The borrower may engage in risky activities that reduce the likelihood of repayment.

Lenders face the risk of default.

Question 21

What does agency theory analyze?

Answer 21

Agency theory analyzes how asymmetric information impacts economic behavior between two parties (borrowers and lenders).

Question 22

What is Akerlof’s “lemons problem” in adverse selection?

Answer 22

In a used car market:

Buyers can’t determine car quality.

Sellers of good cars leave the market.

Only low-quality cars (lemons) remain.

This leads to market failure.

Question 23

How does Akerlof’s lemons problem relate to financial markets?

Answer 23

Borrowers with high risk are more likely to seek loans.

Lenders cannot easily identify good borrowers.

Good borrowers may leave the market, reducing overall loan quality.

Question 24

What are four solutions to adverse selection in financial markets?

Answer 24

Private production and sale of information (e.g., credit rating agencies). Government regulation to improve information flow. Financial intermediation (banks) to screen borrowers. Collateral and net worth to secure loans.

Question 25

What is the free-rider problem in adverse selection?

Answer 25

Investors avoid paying for information but still benefit from it. This reduces the incentive to produce information.

Question 26

How does government regulation reduce adverse selection?

Answer 26

Mandatory disclosure of financial information. Audits to ensure accurate reporting. Protects lenders by increasing transparency

Question 27

Why do banks help reduce adverse selection?

Answer 27

Banks conduct private screening and loan evaluation. They avoid the free-rider problem by keeping loans private. This explains why indirect finance is more common

Question 28

How does collateral solve adverse selection?

Answer 28

Collateral is pledged property that guarantees loan repayment. High-risk borrowers are less likely to apply if collateral is required.

Question 29

How does net worth reduce adverse selection?

Answer 29

Net worth = Assets - Liabilities. High net worth firms are less likely to default, reducing lender risk.

Question 30

Which facts do the solutions to adverse selection explain?

Answer 30

Fact 3, 4, 6: Banks dominate finance due to private screening. Fact 5: Government regulations improve information flow. Fact 7: Collateral reduces lender risk.

Question 31

Why do large, well-established firms have easier access to finance?

Answer 31

They have higher net worth and better credit history. This reduces adverse selection risk for lenders.

Question 32

What happened in the Enron Implosion?

Answer 32

Enron Corporation (energy trading company) was the 7th largest in the U.S. in Aug 2000. Filed bankruptcy in Dec 2001 due to accounting fraud (hiding debt). Several executives were jailed. Largest bankruptcy in U.S. history at that time.

Question 33

What lesson did the Enron scandal teach?

Answer 33

Government regulation can reduce asymmetric information problems but cannot eliminate them. Managers can hide financial problems, making it hard for investors to know a company’s true value.

Question 34

What is the Principal-Agent Problem in equity contracts?

Answer 34

Principal (stockholders) = Own the company but have less information. Agent (managers) = Control the company and have more information. Conflict: Managers may pursue personal benefits instead of maximizing shareholder value.

Question 35

Why does the Principal-Agent Problem occur?

Answer 35

Separation of ownership and control. Stockholders want profits; Managers may prioritize personal benefits and power.

Question 36

What is costly state verification in solving the Principal-Agent Problem?

Answer 36

Monitoring managers through frequent audits, management checks, etc. It is costly and leads to a free-rider problem. Free-riders benefit without paying for monitoring.

Question 37

How does the free-rider problem affect monitoring?

Answer 37

Some shareholders pay for audits/monitoring. Others benefit from the audit without contributing. This reduces the incentive to monitor.

Question 38

How does government regulation help solve the Principal-Agent Problem?

Answer 38

Government regulation increases information transparency. Punishes fraudulent behavior (like Enron). However, catching fraud is still challenging.

Question 39

How does financial intermediation reduce the Principal-Agent Problem?

Answer 39

Example: Venture capital firms invest directly in startups. They monitor activities closely because they own a stake. Reduces the free-rider problem.

Question 40

How do debt contracts reduce the Principal-Agent Problem?

Answer 40

Debt contracts require fixed repayments regardless of performance. If the firm performs well -> no monitoring. If the firm underperforms -> lender increases monitoring.

Question 41

Why do debt contracts still have moral hazard issues?

Answer 41

Borrowers may take on riskier projects than lenders would like. This increases the chance of default. Lenders still face moral hazard despite fixed payments.

Question 42

How does the Enron scandal relate to moral hazard?

Answer 42

Managers hid the company’s true financial status. This is an example of moral hazard in equity contracts. Investors suffered major losses.

Question 43

Which fact does the Principal-Agent Problem relate to most?

Answer 43

Fact 1: Stocks are not the most important source of external financing. Fact 5: Government regulation is heavily involved in financial markets.

Question 44

How does net worth and collateral reduce moral hazard in debt contracts?

Answer 44

Involves the borrower in losses, reducing the incentive for risky investments. Aligns the interests of lender and borrower. This is called incentive-compatible behavior.

Question 45

What are the four types of restrictive covenants in debt contracts?

Answer 45

Discourage undesirable behavior (e.g. high-risk investments). Encourage desirable behavior (e.g. maintaining positive cash flow). Keep collateral valuable (e.g. maintaining assets). Provide information (e.g. regular financial reports).

Question 46

Why is monitoring and enforcing restrictive covenants important?

Answer 46

Prevents borrowers from engaging in risky activities. Ensures collateral value is maintained. Reduces free-rider problems by requiring constant monitoring.

Question 47

How does financial intermediation solve moral hazard in debt contracts?

Answer 47

Banks provide private loans that are not publicly traded. This eliminates free-riding because no third party can benefit from monitoring without contributing. Direct loans => better monitoring. Relates to Facts 3 and 4 (importance of intermediaries).

Question 48

What is a conflict of interest in financial markets?

Answer 48

When financial institutions provide multiple services (auditing, consulting, underwriting), their objectives may conflict. This can result in misleading information to the public. Increases asymmetric information in the market.

Question 49

Why are conflicts of interest harmful in financial markets?

Answer 49

Reduces the quality of information in the market. Financial markets may fail to allocate funds to productive investments. Decreases efficiency in the economy.

Question 50

What is the conflict of interest in investment banks?

Answer 50

Investment banks perform two conflicting roles: - Research companies issuing securities. - Underwrite securities and sell them to the public. The bank may bias information to secure higher underwriting revenues.

Question 51

What is "spinning" in investment banking?

Answer 51

Spinning occurs when banks allocate under-priced IPO shares to third-party companies in exchange for future business. This biases the market and misleads investors.

Question 52

What conflict of interest exists in auditing and consulting firms?

Answer 52

Auditors may skew their judgments to secure consulting business. They may provide favorable audits to retain clients. This leads to misleading financial information.

Question 53

How do credit rating agencies face conflicts of interest?

Answer 53

Issuers of securities pay credit agencies to get a credit rating. Agencies may provide favorable ratings to keep business. This reduces the reliability of credit ratings.

Question 54

How do conflicts of interest increase asymmetric information?

Answer 54

Misleading information causes investors to make poor investment decisions. Funds may be misallocated, reducing economic efficiency. Markets become less reliable.