V how moral hazard affects the choice between debt

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willing to lend and adverse    selections issues minimized. V. How Moral Hazard Affects the Choice Between Debt and Equity Contracts  Asymmetric information problem occurring after a financial transaction A. Moral hazard in equity contracts: the principal agent problem  – principal-agent problem – managers of a corp who own a small fraction of the  stock of a company are the agents; shareholders who own most of the  company’s stock (equity) are considered the principals.  Thus, separation of  ownership from control leading to conflict of interest; stockholders want maximum profit and managers may have less incentive to maximize profits.  Emergence of 
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moral hazard issues.  Manager may engage in activities harmful to the firm such  as diverting corp funds for personal use (Enron, e.g.).  Shareholders not privy to  information that would enable them to predict such behavior. B. Tools to solve principal-agent problem – Promotion of information: monitoring – stockholder to audit the firm, but this  can be expensive in terms of time and money (costly state verification).  Free- rider problem emerges; if you know other shareholders are paying to monitor  activities of the co., you may free ride on their activities; end result no  shareholders willing to pay for monitoring manager’s activities.  Moral hazard  persists, making it difficult for firms to issue shares of common stock to raise  capital.  C. Govt regulation to increase information – laws establishing standard accounting principles – imposing stiff criminal penalties on managers engaged in fraud D. Financial Intermediation (indirect finance) – venture capital firm helps reduce moral hazard; these firms pool the resources  of partners and use funds too assist entrepreneurs start new businesses. Owners of the venture firm receive equity share in the new business and insist on  becoming members of the board of directors of the new business (acquiring  information on activity of mgtm).  Stock ownership only available to venture  capital firm, thereby resolving free rider problem and moral hazard issues.   Venture capital firms have been very important in the high-tech industry in the  U.S. E. Debt Contracts – debt contract (bond or bank loan) is a contractual agreement to pay the lender  fixed dollar amounts at periodic intervals.  If a firm is profitable and is meeting its  debt obligation, the lender is not overly concerned with manager’s illegal  activities; in case of default, lender becomes concerned and will act more like  equity holders.  Lenders will have less frequent need to monitor the firm as  compared to shareholder and this lowers   cost of state verification to them.  
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