Econ 330 Test 2 On Ch 8 10 11 12 16 38 question and short answer packet Ch 8 An Economic Analysis of Financial Structure Key Terms Agency Theory analysis of how asymmetric information problems affect economic behavior Collateral Backing of loan with another item property Costly State Verification The high price to verify monitor executive decisions Free rider problem occurs when people who do not pay for information take advantage of the information that other people have paid for Incentive compatible aligns the incentives of the borrower with those of the lender Net worth equity capital difference between the firms assets and its liabilities more net worth less likely to default Principal agent problem when managers own only a small fraction of the firm they work for Creates a separation of ownership Restrictive covenants provisions that restrict and specify certain activities a borrowed of a bond or loan can do Secured debt collateralized debt backed by something State owned banks No need to make a profit so little incentive to allocate capital in most productive ways Unsecured debts credit card debt widely used as business borrowing Venture capital firm pool funds from partners and invest with budding entrepreneurs Notes Basic Facts about Financial Structure throughout the world o Eight facts about the financial structure of the world 1 Stock are not the most important source of external financing 2 3 for businesses Issuing marketable debt and equity securities is not the primary way in which business finance their operations Indirect finance which involves the activities of financial intermediaries is many times more important than direct finance in which businesses raise funds directly from lender in financial markets 4 Financial intermediaries particularly banks are the most important source of external funds used to finance businesses 5 The financial system is among the most heavily regulated sectors of the economy 6 Only large well established corporations have easy access to securities markets to finance their activities 7 Collateral is a prevalent feature of debt contracts for both households and businesses 8 Debt contracts typically are extremely complicated legal documents that place substantial restrictions of the behavior of the borrower Transaction Costs o How transactions costs influence financial structure Only half of American households own securities So expensive and some people do not enough money to diversify Financial intermediaries reduce transaction costs o Economies of scale Bundling investors together Mutual fund Sells shares to individuals and invests their funds Companies have so much money they can diversify o Better at investing and specialize in liquidity services Getting their customers money out Asymmetric information Adverse selection and moral hazard o Asymmetric information one party does not know enough about the other party o Adverse selection the problem created by asymmetric information before the transaction occurs before the transaction o Moral hazard problem created by asymmetric information after the transactions occurs after the transaction o Agency Theory analysis of how asymmetric information problems affect economic behavior The Lemons Problem How Adverse Selection Influences Financial structure o Lemons in the Stock and Bond Markets refers to the car Same problem for bond and stock markets Explains fact 1 and 2 If people do not have enough information to decipher between the good companies and the bad companies they will only accept an average between the two rates common stock and that will mean the good companies are being undervalued and they will not sell o Tools to help solve can be productive With asymmetric information problem goes away and market Private production and sale of information Moody s S P and Value line gather info on companies and sell to subscribers Still a free rider problem o People use your advice that you acquired from subscribing Government Regulation to increase information U S uses the SEC to regulate markets and make financial information available to all o Helps make markets efficient and reduces Financial Intermediation adverse selection Think about the car market need a dealer intermediary to sell buy o Everyone profits from this Explains why banks are the most important source of funds for companies Collateral and Net Worth Collateral reduces the consequences of adverse selection because it reduces losses in case of default o Also gives a better loan rate Net worth gives firms a cushion of its assets to pay off its loans How Moral Hazard Affects the Choice between Debt and Equity Contracts o Moral Hazard occurs after the financial transaction Explains why its easier to raise funds with debt than equity o Moral Hazard in Equity Contracts The Principal Agent Problem Equity contracts are subject to the principal agent problem The separation between ownership stockholders and control executives because they have less incentive to maximize profits Executives know more about the company then stockholders and can do things for their benefit rather then for the true owners o Tools to Help Solve the Principal Agent Problem Production of Information Monitoring Costly State Verification refers to the expensive costs to monitor managers o Free Rider problem also an issue why would only some stockholders pay to monitor company Government Regulation to Increase Information Increase regulation and punishments on people who commit fraud and steal corporate profits Financial Intermediaries indirect finance is so important to avoid the free rider problem Venture capitalists are particularly important o Take partial equity stake in company but also put own people in company to assure things are okay nobody else can buy into the company so no free rider s Debt Contracts Important because they require less verification of companies profits Only care that they get paid on time and if company cannot pay they get first share of income only time need to investigate firm How Moral Hazard Influences Financial Structure in Debt Markets o Still important to regulate because borrowers have the incentive to use the money for a risky investment because loss of funds is not their problem o Tools to Solve Net Worth and Collateral The more someone has invested in the company net worth the less likely they will be risky with their own investments o High net worth less of a moral hazard problem easier to borrow Monitoring and