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The most obvious strategy is to deny subsequent loan

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Unformatted text preview: 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 constraints placed on it by the loan provisions, the firm should benefit by obtaining funds at a lower cost. Asymmetric Information pecking order A hierarchy of financing that begins with retained earnings, which is followed by debt financing and finally external equity financing. asymmetric information The situation in which managers of a firm have more information about operati...
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