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Unformatted text preview: ain 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
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 440 PART 4 Long-Term Financial Decisions investments pay off, the owners receive all the benefits; but if the risky 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
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This document was uploaded on 03/30/2014.
- Spring '14