Chapter 8

Question 1

1. Stocks are not the most important source of external financing for businesses.
2. Issuing marketable debt (bonds) and equity (stock) securities is not the primary way in which businesses finance their operations.
3. Indirect finance, which involves financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets (stock and bond markets)
4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. (56% in the U.S.; over 70% in Germany, Japan, and Canada)

Answer 1

Basic facts about the global financial system:

Question 2

can keep small savers and borrowers out of direct involvement in the financial markets. (Fact 3)

Answer 2

Transaction costs

Question 3

Financial intermediaries can reduce transaction costs through

Answer 3

Economies of scale (able to spread fixed costs over many transactions)

Expertise allows them to offer convenient services.

Question 4

reduces the consequences of adverse selection

Answer 4

Collateral

Question 5

The principal agent problem occurs when

Answer 5

Managers (agents) who control the firm own very little of it.

Question 6

Firms have the incentive to take on riskier investment projects then debt holders would like which contributes to moral hazard in debt contracts.

Tools to reduce moral hazard in debt contracts include:

Answer 6

Net worth and collateral- if borrowers have more at stake, there is less chance they behave in risky manner (Fact 6 and 7)

Monitoring and enforcement of restrictive covenants- can be used to limit risky activities and encourage desirable activities (Fact 8)

Financial intermediation- more effective than bondholders in monitoring and enforcement (Fact 3 and 4)