Unformatted text preview: y investments do not pay off, the lenders share in the costs.
Clearly, an incentive exists for the managers acting on behalf of the stockholders to “take advantage” of lenders. To avoid this situation, lenders impose
certain monitoring techniques on borrowers, who as a result incur agency costs.
The most obvious strategy is to deny subsequent loan requests or to increase the
cost of future loans to the firm. Because this strategy is an after-the-fact approach,
other controls must be included in the loan agreement. Lenders typically protect
themselves by including provisions that limit the firm’s ability to alter significantly its business and financial risk. These loan provisions tend to center on
issues such as the minimum level of liquidity, asset acquisitions, executive
salaries, and dividend payments.
By including appropriate provisions in the loan agreement, the lender can
control the firm’s risk and thus protect itself against the adverse consequences of
this agency problem. Of course, in exchange for incurring agency costs by agreeing to the operating and financial constrai...
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