Incentives in Business Investment
Imagine a business structure where the owners' potential financial loss is capped at the amount they invested, meaning their personal assets are safe if the business fails. Explain why this structure might encourage the owners to approve a high-risk, high-reward project over a safer, more predictable one, even if the high-risk project has a significant chance of failing and leaving creditors unpaid.
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Economics
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Introduction to Macroeconomics Course
Ch.6 The financial sector: Debt, money, and financial markets - The Economy 2.0 Macroeconomics @ CORE Econ
The Economy 2.0 Macroeconomics @ CORE Econ
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Corporate Investment Decision
A corporation is choosing between two investment strategies. Strategy X offers a moderate, reliable profit. Strategy Y is much riskier, with a small chance of an extremely high profit but a large chance of a loss that would bankrupt the company and leave its lenders unpaid. Why might the corporation's shareholders, whose personal wealth is shielded from the company's debts, prefer the riskier Strategy Y?
Shareholder Risk vs. Creditor Security
Incentives in Business Investment
A company's legal structure ensures that its owners can only lose the money they have invested in the business; their personal assets are not at risk if the company fails. In this situation, the company's owners and its lenders (e.g., banks that have provided loans) will generally have the same preference for low-risk, stable business projects.
Divergent Interests in Corporate Finance
A company's legal structure protects its owners' personal assets from being used to pay company debts. Match each stakeholder group with their most likely investment preference and the primary reason for that preference.
Policy Design to Mitigate Corporate Moral Hazard
A corporation, whose owners are legally protected from losing more than their initial investment if the company fails, is considering a new project. The project is extremely risky: it has a small chance of yielding enormous profits but a very high probability of causing the company to fail and default on its loans. Under which of the following circumstances would the owners have the greatest incentive to proceed with this risky project?
A biotech startup, funded by $10 million from its owners and $50 million in loans, is pursuing a new drug. The project has a 10% chance of a $1 billion profit but a 90% chance of failure, which would bankrupt the company, leaving the loans unpaid. A financial analyst states, 'The legal rule that shields the owners' personal wealth from the company's debts is the key factor driving the decision to undertake this project.' Which of the following statements provides the best evaluation of the analyst's claim?