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The owners give the managers the authority to manage

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Unformatted text preview: rest rate charged is based on the lender’s assessment of the firm’s risk. The lender–borrower relationship, therefore, depends on the lender’s expectations for the firm’s subsequent behavior. The borrowing rates are, in effect, locked in when the loans are negotiated. After obtaining a loan at a certain rate, the firm could increase its risk by investing in risky projects or by incurring additional debt. Such action could weaken the lender’s position in terms of its claim on the cash flow of the firm. From 532 PART 4 Long-Term Financial Decisions Hint Typical loan provisions included in corporate bonds are discussed in Chapter 6. another point of view, if these risky investment strategies paid off, the stockholders would benefit. Because payment obligations to the lender remain unchanged, the excess cash flows generated by a positive outcome from the riskier action would enhance the value of the firm to its owners. In other words, if the risky investments pay off, the owners receive all the benefits; but if the risk...
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