7211TutAnswersWk13 - Tutorial Questions for Chapter 13...

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Tutorial Questions for Chapter 13 Review Questions 13-10 The agency problem occurs because lenders provide funds to a firm based on their expectations for the firm's current and future capital expenditures and capital structure, which determine the firm's business and financial risk. Firm managers, as agents for the owners, have an incentive to "take advantage" of lenders. Lenders have an incentive to protect their own interests and have developed monitoring and controlling techniques to do so. Lenders protect themselves by means of loan covenants that limit the firm's ability to significantly change its business or financial risk. These covenants may include maintaining a minimum level of net working capital, restrictions on asset acquisitions and additional debt (through minimum coverage ratios), executive salaries and dividend payments. The firm incurs agency costs when it agrees to the operating and financial provisions in the loan agreement. Since the firm's risk is somewhat controlled by the covenants, the lender can provide funds at a lower cost, which benefits the firm and its owners. 13-11 Asymmetric information results when a firm's managers have more information about operations and future prospects than do investors. This additional information will generally cause financial managers to raise funds using a pecking order (a hierarchy of financing beginning with retained earnings, followed by debt, and finally, equity) rather than maintaining a target capital structure. This might appear to be inconsistent with wealth maximisation, but asymmetric information allows management to make capital structure decisions which do, in fact, lead to wealth maximisation. Because of management's access to asymmetric information, the firm's financing
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This note was uploaded on 10/10/2010 for the course ECON 7300 at University of Sydney.

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7211TutAnswersWk13 - Tutorial Questions for Chapter 13...

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