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How firms choose between sources of financial capital

There are clear patterns in how businesses raise financial capital. These patterns can be explained in terms of imperfect information, which as discussed in Information, Risk, and Insurance , is a situation where buyers and sellers in a market do not both have full and equal information. Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital.

Any young startup firm is a risk; indeed, some startup firms are only a little more than an idea on paper. The firm’s founders inevitably have better information about how hard they are willing to work, and whether the firm is likely to succeed, than anyone else. When the founders put their own money into the firm, they demonstrate a belief in its prospects. At this early stage, angel investors and venture capitalists try to overcome the imperfect information, at least in part, by knowing the managers and their business plan personally and by giving them advice.

Accurate information is sometimes not available because corporate governance    , the name economists give to the institutions that are supposed to watch over top executives, fails, as the following Clear It Up feature on Lehman Brothers shows.

How did lack of corporate governance lead to the lehman brothers failure?

In 2008, Lehman Brothers was the fourth largest U.S. investment bank, with 25,000 employees. The firm had been in business for 164 years. On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection. There are many causes of the Lehman Brothers failure. One area of apparent failure was the lack of oversight by the Board of Directors to keep managers from undertaking excessive risk. Part of the oversight failure, according to Tim Geithner’s April 10, 2010, testimony to Congress, can be attributed to the Executive Compensation Committee’s emphasis on short-term gains without enough consideration of the risks. In addition, according to the court examiner’s report, the Lehman Brother’s Board of Directors paid too little attention to the details of the operations of Lehman Brothers and also had limited financial service experience.

The board of directors, elected by the shareholders, is supposed to be the first line of corporate governance and oversight for top executives. A second institution of corporate governance is the auditing firm hired to go over the financial records of the company and certify that everything looks reasonable. A third institution of corporate governance is outside investors, especially large shareholders like those who invest large mutual funds or pension funds. In the case of Lehman Brothers, corporate governance failed to provide investors with accurate financial information about the firm’s operations.

As a firm becomes at least somewhat established and its strategy appears likely to lead to profits in the near future, knowing the individual managers and their business plans on a personal basis becomes less important, because information has become more widely available regarding the company’s products, revenues, costs, and profits. As a result, other outside investors who do not know the managers personally, like bondholders and shareholders, are more willing to provide financial capital to the firm.

Questions & Answers

pls who is a consumer
Cobby Reply
whoever use the product can be the consumer either the buyer of it or people at home who will be using the product
Donatius
compensation of goods and services by a customer with price that willing to satisfy themselves.
Kho
who describe economic
yao Reply
thediminishingarginalutility
Stanley Reply
mean
yao
pls I'm a home economic student and went I was in my formal school I was doing biology so wen I got she 2 and I went a different school and that school they don't do biology what they do is economics and I don't understand it cos I didn't learn from form one so I will need ur help in this please
Hawa Reply
what help u need
Fatema
I don't understand it I tried to learn from form one but still don't understand
Hawa
jxt follow the notes well try solving question under it
Nana
important of economics
Benita Reply
what is supply chain
Jos Reply
what is financial management? And why is it necessary in business ?
Fatema Reply
it is the managing of all transactions that take place in any business and if not managed properly it could create debts and destroy the business
Asive
What is demand?
Annonymous Reply
why is degree important in economics
Ebunoluwa Reply
important of enocomic
Adu Reply
what is division of labour
Dennis Reply
division of labour can be defined as the separation of task to individuals in any economic system to specialize on it.
Ahmad
what is demand curve
Victoria Reply
demand curve is a downward sloping economic graph that shows the relationship between the price of product and the quantity of the product demanded.
Ahmad
What is demand
Frank Reply
It refers to the quantity of a commodity purchased in the market at a price and at a point of time.
Basanta
refers to amount of commodities a consumer is willing and able to buy at particular price within a period of time
Clifford
It is the ability and willingness a customer buys a product or service at a particular price, place and time while other things remaining constant or the same
kum
It refers to the quality of a commodity purchased in the market at a price and at a point of time .
Cobby
demand refers to the quantity of goods and services a consumer is willing and able to buy at a given price within a a specific period of time
Tina
In which case is opportunity cost is zero
Francis Reply
where no alternative is available
Bhartendu
who is the father of economic
Omar Reply
Adam Smith
Suraj
ok
Tony
Adam Smith
Francis
Adam smith
Opana
Adam Smith
Basanta

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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