Most to Least Important Sources of Financing
• Indirect finance (loans from financial intermediaries like banks) is far more
important than direct finance (stocks and bonds).
• Banks are the most important source of external funds for businesses,
especially for small and medium enterprises.
• Marketable debt and equity securities are not the primary way businesses finance
their operations .
Role and Use of Collateral
• Collateral is a prevalent feature of debt contracts, reducing lender risk by
securing the loan with an asset.
• It mitigates adverse selection by ensuring that only borrowers confident in their
repayment ability seek loans.
• It also reduces moral hazard by giving borrowers an incentive to fulfill their
obligations .
Purpose and Role of Restrictive Covenants
• Restrictive covenants are contractual provisions that limit borrower behavior to
reduce lender risk.
• They can:
o Discourage undesirable behavior (e.g., restricting risky investments).
o Encourage desirable behavior (e.g., maintaining insurance on collateral).
o Keep collateral valuable (e.g., requiring asset maintenance).
o Provide financial information to lenders .
Role of Financial Intermediaries in the Market
• Reduce transaction costs through economies of scale and expertise.
• Mitigate asymmetric information by screening borrowers and monitoring loans.
• Solve adverse selection and moral hazard by using collateral, restrictive
covenants, and long-term relationships .
