Question

Explain how risk-shifting, on the one hand, and the conflict between inside and outside equity, on
the other hand, creates a trade-off between debt and equity financing.(would appreciate if you can post answers by writing down the words on web page instead of pictures in case i cannot look clearly of each words)

Answer 1

Debt and equity financing poses different issues to the firm. Debt financing attracts financial risk that increases with the increase in debt in the capital structure. This risk is reduced by going for the equity financing. But, equity financing involves conflict between inside and outside equity. Here, inside equity is represented by the manager with equity stake and outside equity is represented by the shareholders who are outside of the organization. Hence, opting for the equity financing can reduce the risk, but increases the conflict between inside and outside equity and it brings a tradeoff when deciding the capital structure. Eliminating the conflict, increases the risk, but reducing the risk increases the conflict of inside and outside equity. Now the owner of the business, has to decide and create a balance between the two type of financing.