Copyright © 2009 Pearson Prentice Hall. All rights reserved Facts of Financial Structure 1.Stocks are not the most important source of external financing for businesses. 2.Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Facts of Financial Structure 3.Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance. 4.Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. Only large, well- established corporations have easy access to securities markets to finance their activities

Copyright © 2009 Pearson Prentice Hall. All rights reserved Facts of Financial Structure 5. Collateral is a prevalent feature of debt contracts for both households and businesses. 6. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers: restrictive covenants.

Collateral Debt is subject to adverse selection. Collateral reduces the consequences of adverse selection because it reduces the lender’s losses in the event of a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for the losses on the loan. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-4

Collateral Collateral is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments Collateralized debt or secured debt Ex: your house is collateral for your mortgage Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-5

Copyright © 2009 Pearson Prentice Hall. All rights reserved Collateral Debt is subject to moral hazard. In fact, debt may create an incentive to take on very risky projects. This is important to understand. Let’s looks at a simple example.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Collateral Most debt contracts require the borrower to pay a fixed amount (interest) and keep any cash flow above this amount. For example, what if a firm owes $100 in interest, but only has $90? It is essentially bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash.

Collateral When the collateral pledged to a lender is valuable, the risk of moral hazard will be greatly reduced because the borrowers themselves have a lot to lose. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-8

Copyright © 2009 Pearson Prentice Hall. All rights reserved How Moral Hazard Influences Financial Structure in Debt Markets Other Tools to Help Solve Moral Hazard in Debt Contracts 1.Net Worth 2.Monitoring and Enforcement of Restrictive Covenants. Examples are covenants that … 1.discourage undesirable behavior 2.encourage desirable behavior 3.keep collateral valuable 4.provide information

Restrictive covenants Covenants to discourage undesirable behavior Some covenants mandate that a loan can be used only to finance specific activities, such as the purchase of particular equipment or inventories. Copyright © 2009 Pearson Prentice Hall. All rights reserved

Restrictive covenants Covenants to encourage desirable behavior They encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off Life insurance that pays off the mortgage upon the borrower’s death Copyright © 2009 Pearson Prentice Hall. All rights reserved

Restrictive covenants Covenants to keep collateral valuable Restrictive covenants can encourage the borrower to keep the collateral in good condition and make sure that it stays in the possession of the borrower Insurance on the home Copyright © 2009 Pearson Prentice Hall. All rights reserved

Restrictive covenants Covenants to provide information Restrictive covenants can require a borrower to provide information about its activities periodically Balance sheet, income reports Copyright © 2009 Pearson Prentice Hall. All rights reserved