Question 1: Describe a principal-agent relationship.

a. a principal makes a decision that affects an agent

b. an agent makes a decision that affects a principal

c. an employee acting on behalf of its employer can be viewed as an agent

d. a lawyer acting on behalf of its client can be viewed as a principal

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 2: Describe and discuss the asset substitution problem.

a. riskier assets are substituted for existing assets

b. debtholders lose more than they would have if the riskier assets fail, shareholders get more than they would have if the riskier assets succeed

c. shareholders gain at the debtholders' expense

d. it is like the shareholders are gambling for their own benefit with the debtholders' money

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 3: Describe and discuss the underinvestment problem.

a. it is essentially the mirror image of asset substitution

b. shareholders refuse to undertake a low-risk positive-NPV investment because debtholders would gain at shareholders' expense

c. debtholders' would gain from the investment because the probability that they will be fully repaid increases

d. an investment with a large-enough positive NPV can overcome the problem of underinvestment

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 4: Define the term moral hazard

a. it is an ethical violation

b. it is a legal violation

c. it is an opportunity for an agent to take unobserved actions for personal benefit at the expense of the principal

d. it is a moral violation

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 6: Define the concept of agency problems

a. it is when a principal is unsatisfied with an agent

b. it is when there is a potential conflict of interest between the principal and the agent

c. asset substitution and underinvestment are agency problems

d. employees not working when they are supposed to be working is an agency problem

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 9: Describe the uniqueness of assets creates agency costs for shareholders.

a. employees can demand a risk premium (higher compensation) for their effort to develop specialized talent that is not valuable to other employers

b. lenders can demand a risk premium (higher interest rate) for loaning against a unique asset (collateral)

c. new shareholders can demand a risk premium (higher required rate of return) for investing in a firm that uses unique assets

d. customers can demand a risk premium (lower price) for buying a product from a firm that uses unique assets

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 11: How can product and service guarantees create -- an agency problem between the firm and its consumers?

a. the firm has the option to repair rather than replace a defective product

b. the firm has the option to not honor the guarantee

c. the firm has the option to recall defective products

d. the firm has the option to refund the price of the product rather than provide a fully functioning product

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 13: Define the concept of an optimal contract.

a. an optimal contract minimizes total agency costs

b. an optimal contract takes into account monitoring costs

c. an optimal contract takes into account misbehavior costs

d. an optimal contract takes into account contracting costs

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 16: Using the stock-as-an-option view, explain why stockholders might choose to undertake a high-risk investment, even if the NPV of the investment is negative. What group is on the other side of this transaction?

a. this is the asset substitution problem

b. debtholders are on the other side of the transaction

c. higher risk in the underlying assets increases the value of an option on those assets, and the increase in value can more than cancel out the negative NPV

d. managers are on the other side of the transaction

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 17: Using the stock-as-an-option view, explain why stockholders might choose not to undertake a low-risk investment, even if the expected NPV of the investment is positive. What group is on the other side of this transaction?

a. this is the underinvestment problem

b. debtholders are on the other side of the transaction

c. lower risk in the underlying assets decreases the value of an option on those assets, and the decrease in value can more than cancel out the positive NPV

d. customers are on the other side of the transaction

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 18: Using the stock-as-an-option view, describe the problem of claim dilution.

a. it reduces debtholder value by increasing the ratio of debt-to-asset value

b. claim dilution via dividends reduces the value of the assets supporting the debt

c. claim dilution via new debt increases the value of the assets supporting the debt

d. increasing the ratio of debt to asset value increases the debtholders' risk

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 20: Explain the problem of the nondiversifiability of human capital.

a. the unique skills and knowledge an employee must learn in a particular job with a particular firm may have less (or no) value in another job

b. a stockholder's investment is easily diversified at very little cost, so stockholders care only about non-diversifiable risk

c. employees bear total risk (diversifiable plus non-diversifiable risk), whereas shareholders can easily choose to bear only non-diversifiable risk

d. employees may refuse to undertake a very positive-NPV investment because it has a large amount of diversifiable risk

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 22: How an agent's desire to maintain the ongoing value of a good reputation can facili- tate shareholder monitoring of the agent.

a. employees with good reputations are able to demand more compensation for their work

b. employees who are caught misbehaving risk losing that higher compensation for their work

c. reputation facilitates shareholder monitoring because employees are less likely to misbehave if the cost of getting caught and losing their reputation is high

d. desire to maintain a good reputation does not facilitate shareholder monitoring

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 24: Explain why the stock price

a. because of limited liability, stockholders cannot be required to make additional payment

b. stock can be viewed as an option on the firm's assets

c. options are valuable

d. hey, you never know

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 26: Perfect monitoring in a perfect market environment always provides an optimal contract. Explain why monitoring is not always the best choice, even in a well-functioning market environment with low transaction costs.

a. monitoring is not always successful

b. the cost of monitoring can exceed the expected costs of misbehavior

c. monitoring can be difficult

d. monitoring is always best

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 27: Respond to the following statement: Because a firm can lower its interest cost by including more restrictive covenants in its bond indentures, a firm should use the most restrictive set of covenants it can in order to achieve the lowest interest cost. [Hint: The answer involves two different aspects, and the less obvious one has to do with options.]

a. the interest savings may not be worth the cost

b. rather than most restrictive, use the set of covenants that minimizes the total contract cost, including opportunity costs

c. restrictive covenants can be like overlapping options, where the extra covenant does not add its full value but does inflict its full cost

d. restrictive covenants can eliminate one or more real options a firm might otherwise have

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 29: In some bankruptcy settlements, the debtholders accept less than full payment on the claim and at the same time they agree to allow the stockholders to get a payment as well. Because the stockholders are only the residual claimants (after the debtholders get what they have been promised), why do the debtholders agree to this? (Hint: Consider our example of the "unnecessary" payment the Seven-Up Company and the Dr. Pepper Company made to their debtholders in exchange for their consent to the leveraged buyoutthe hidden option

a. the bankruptcy court believes in fairness

b. debtholders want to avoid a costly legal battle

c. the debtholders feel sorry for the shareholders

d. shareholders have the option to "make trouble"

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true

Question 32: Explain how a complex multilevel organization provides a natural form of agent monitoring.

a. generally speaking, one level directly monitors the level immediately below it and indirectly monitors additional levels below that, so with more levels there is more monitoring

b. with more monitoring, successfully "pulling off" misbehavior requires that more people be involved

c. the more people involved, the harder it is to keep the misbehavior secret

d. the more people involved, the more likely it is to include honest people who will not "play along"

e. A and B

f. A and C

g. A and D

h. B and C

i. B and D

j. C and D

k. all but A

l. all but B

m. all but C

n. all but D

o. all are true