Why do firms rely more on loans and bonds than on stocks as a source of external finance?

Investors are more willing to buy bonds than stock, which explains why bonds are a more
important source of external finance for firms. Small to medium-sized firms are unable to issue
either bonds or stock and must rely on bank loans as their main source of external finance.

Transactions costs The cost of a trade or a financial transaction; for example, the brokerage
commission charged for buying or selling a financial asset.

Information costs The costs that savers incur to determine the creditworthiness of borrowers
and to monitor how they use the funds acquired.

Economies of scale The reduction in average cost that results from an increase in the volume
of a good or service produced.

Asymmetric information The situation in which one party to an economic transaction has
better information than does the other party.

Adverse selection The problem investors experience in distinguishing low-risk borrowers

from high-risk borrowers before making an investment.

Moral hazard The risk that people will take actions after they have entered into a transaction
that will make the other party worse off.

Economists distinguish between two problems arising from asymmetric information: 1.

Adverse selection

2. Moral hazard

Collateral Assets that a borrower pledges to a lender that the lender may seize if the
borrower defaults on the loan.

Net worth The difference between the value of a firm's assets and the value of its liabilities.

Credit rationing The restriction of credit by lenders such that borrowers cannot obtain the
funds they desire at the given interest rate.

The disclosure of information required by the SEC reduces the information costs of adverse
selection, but it doesn't eliminate them for four key reasons:1. Some good firms may be too
young to have much information for potential investors to evaluate.
2. Lemon firms will try to present the information in the best possible light so that investors will
overvalue their securities.
3. There can be legitimate differences of opinion about how to report some items on income
statements and balance sheets.
4. The interpretation of whether information is material can be tricky.

( see examples page 286)

Relationship banking The ability of banks to assess credit risks on the basis of private
information about borrowers.

Principal-agent problem The moral hazard problem of managers (the agents) pursuing their
own interests rather than those of shareholders (the principals).

Restrictive covenant A clause in a bond contract that places limits on the uses of funds that a
borrower receives.

Relationship banking The ability of banks to assess credit risks on the basis of private
information about borrowers.

Principal-agent problem The moral hazard problem of managers (the agents) pursuing their
own interests rather than those of shareholders (the principals).

Venture capital firm A firm that raises equity capital from investors to invest in startup firms.

Private equity firm (or corporate restructuring firm) A firm that raises equity capital to acquire
shares in other firms to reduce free-rider and moral hazard problems.