Consider a firm with risky debt outstanding which requires a repayment one period hence.There are no taxes and the firm has a risky project that can be financed using retained earnings.Assume that the firm's manager acts in the best interest of the shareholders.In this scenario, moral hazard exists if
A)the project has a positive net present value and is undertaken so as to maximize the firm's total value
B)the project has a positive net present value and is undertaken to maximize the shareholders' wealth
C)the project has a negative net present value and is undertaken to maximize the shareholders' wealth
D)the project has a zero net present value and is undertaken
E)moral hazard never exists

Question

Quizplus · Accepted Answer

Moral hazard exists when the borrower (the firm in this case) takes on more risk than the lender (the bondholders) agreed upon because the borrower has an incentive to do so. In this scenario, if the manager takes on a project with a negative net present value to maximize shareholders' wealth, they are increasing the risk of default on the risky debt, which goes against the interest of the bondholders. This is an example of moral hazard. Choice A and B describe scenarios where the project has a positive net present value and is undertaken with the intention of maximizing the firm's total value or shareholders' wealth, respectively, but this would not necessarily constitute moral hazard. Choice D describes a scenario where the project has zero net present value, so there would be no reason for the manager to undertake it for the purpose of maximizing shareholders' wealth (or otherwise). Choice E is incorrect because moral hazard can and does exist in many contexts.

Consider a Firm with Risky Debt Outstanding Which Requires a Repayment