Part 1Bonds account for a larger fraction of external funds relative to equities raised by American businesses because:Part 2
A. equity contracts do not permit borrowing firms to raise additional funds by issuing debt. B. costly state verification makes the equity contract less desirable than the debt contract. C. of the reduced scope for moral hazard problems under equity contracts as compared to debt contracts. D. there is no moral hazard problem when using a debt contract.

Question

Part 1Bonds account for a larger fraction of external funds relative to equities raised by American businesses​ because:Part 2
A. equity contracts do not permit borrowing firms to raise additional funds by issuing debt. B. costly state verification makes the equity contract less desirable than the debt contract. C. of the reduced scope for moral hazard problems under equity contracts as compared to debt contracts. D. there is no moral hazard problem when using a debt contract.

BlackTom AI · Accepted Answer

Question restatement: The prompt asks why bonds account for a larger share of external funds than equities for American firms, presenting four options to evaluate.
Option A: "A. equity contracts do not permit borrowing firms to raise additional funds by issuing debt." This is inaccurate because equity contracts do not restrict a firm from later issuing debt; firms can simultaneously have equity and debt financing. The claim oversimplifies capital structure possibilities and ignores the contractual and informational frictions that influence funding choices.
Option B: "B. costly state verification makes the equity contract less desirable than the debt contract." This is the standard reasoning in financial contracting: debt contracts enable more efficient monitoring and control through collateral, covenants, and the lender’s oversight, reducing information asymmetry and screening costs. When verification costs are high, lenders prefer debt because it provides a clearer enforcement mechanism and reduces the risk of misuse of funds, making debt more attractive relative to equity.
Option C: "C. of the reduced scope for moral hazard problems under equity contracts as compared to debt contracts." This is misleading. In fact, debt contracts often face more severe moral hazard issues after borrowing (e.g., underinvestment, asset substitution) and require monitoring. Equity contracts, while not free of moral hazard, distribute risk differently and may align incentives, but the statement that equity has reduced moral hazard scope is not a universally valid rule and does not explain why debt dominates external funding.
Option D: "D. there is no moral hazard problem when using a debt contract." This is incorrect because debt contracts do not eliminate moral hazard; they attempt to mitigate it through covenants, collateral, and monitoring, but moral hazard can still occur (e.g., risk-shifting or underinvestment) and thus does not justify exclusive reliance on debt.
Putting the pieces together, the most accurate explanation among the options centers on the role of costly state verification: debt contracts help overcome information asymmetry and verification costs, making them more attractive when these costs are high, which explains bonds supplying a larger share of external funds relative to equity.
In sum, A misstates financing flexibility, B directly ties funding type to verification cost advantages of debt, C mischaracterizes moral hazard dynamics, and D wrongly claims the absence of moral hazard with debt. The correct economic intuition aligns with the idea that costly state verification makes debt contracts more desirable than equity contracts, hence bonds accounting for a larger fraction of external funds.

Homework:Chapter 8 Homework

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Homework:Chapter 8 Homework

View Explanation

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Similar Questions

Which of the following is not a reason that a company would want to issue bonds (debt) instead of stock?

The incentives of equity investors and lenders are well aligned in that both care about improving firms’ long-term value.

Which of the following is NOT debt security?

________ is a contractual obligation to pay back the amount that has been borrowed. The borrower owes principal and interest to the lender. Whereas_____ provides ownership of the company to the shareholders.

________ is a contractual obligation to pay back the amount that has been borrowed. The borrower owes principal and interest to the lender. Whereas_____ provides ownership of the company to the shareholders.

More Practical Tools for Students Powered by AI Study Helper

Making Your Study Simpler

____ is a contractual obligation to pay back the amount that has been borrowed. The borrower owes principal and interest to the lender. Whereas_ provides ownership of the company to the shareholders.

____ is a contractual obligation to pay back the amount that has been borrowed. The borrower owes principal and interest to the lender. Whereas_ provides ownership of the company to the shareholders.