AFF 604- Midterm Exam Guide - Comprehensive Notes for the exam ( 45 pages long!)
12 Oct 2017
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All borrowers only care about themselves , don"t care strategically about lenders or other borrowers: lenders charge a higher interest rate in the expectation that borrowers will act opportunistically. Underinvestment problem: agency problem where a company refuses to invest in low-risk assets, in order to maximize their wealth at the cost of the debt holders. Low-risk projects provide more security for the firm"s debt holders, since a steady stream of cash can be generated to pay off the lenders. The safe cash flow does not generate an excess return for the shareholders. As a result, the project is rejected, despite increasing the overall value of the company. Risk-shifting problem: the transfer of risk to another party. Risk shifting has many connotations, the most common being the tendency of a company or financial institution facing financial distress to take on excessive risk.
