Chapter 8 Flashcards
true or false: stocks are not the most important source of external financing for businesses?
True
True or false: Issuing marketable debt and equity securities is the primary way in which businesses finance their operations
False
What is more important, indirect or direct finance?
indirect finance, which involves the activities of financial intermediaries.
What are the most important source of external funds used to finance businesses?
Financial intermediaries, particularly banks
What is among the most heavily regulated sectors of the economy?
the financial systems
Who have easy access to securities markets to finance their activities?
Only large, well-established corporations
What is a prevalent feature of debt contracts for both households and businesses?
collateral
What are debt contracts?
typically are extremely complicated legal documents that place substantial restrictions on the behaviour of the borrower
How do financial intermediaries reduce transaction costs?
- Economies of scale
- expertise
What are economies of scale?
Investors funds may be bundles together to reduce transaction costs for each individual investor. An example is a mutual fund, which is a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. Because it buys large blocks of bonds or stocks, a mutual fund can take advantage of lower transaction costs.
What is asymmetric information?
A situation where one party’s insufficient knowledge about the other party involved inna transaction makes it impossible for the first party to make accurate decisions when conducting a transaction.
What is agency theory?
the analysis of how asymmetric information problems affect economic behaviour.
Describe the lemons problem in the stock and bond markets?
if someone wants to buy a common stock, the buyer will pay average price, however only the bad firms will want to sell as the average is over the value of these bad stocks. Likewise with bonds, where good firms won’t want to sell in this market as their valuation is above average market price and will not want their bonds undervalued. This means few bonds and stocks will sell in these markets and not be a good source of financing.
This explains why stocks and bonds are not the primary source of financing fr businesses in any country in the world.
What are 4 tools to help solve adverse selection problems?
- Private production and sale of information
- Government regulation to increase information
- Financial intermediation
- Collateral and Net Worth
How can net worth (equity capital) act as collateral?
meaning the difference between a firms assets and its liabilities, it can perform a similar role to collateral. The lender can take title to the firm’s net worth, sell it off, and use the proceeds to recoup some of the losses from the loan.
What is the principal agent problem?
Stockholders who own most of the firm’s equity (principals) are nit the same as the managers of the firm (agents) who only own a small fraction of the firm. Due to the separation in ownership and control, managers may act in their own interests, and have less incentive to maximise profits.
4 tools to help solve the principal agent problem?
- Production of information: monitoring
- Government regulation to increase info
- Financial Intermediation - Venture capital firms
- Debt contract
Tools to help solve moral hazard in debt contracts?
- Net worth and collateral
- Monitoring and enforcement of restrictive covenants
- financial intermediation
What is a restrictive covenants and the 4 types to solve moral hazard?
contracts
- Covenants to discourage undesirable behaviour
- Covenants to encourage desirable behaviour
- Covenants to keep collateral valuable
- Covenants to provide informations
