Question: (Capital structure theory) Which of the following statements most appropriately describes how agency costs affect a firm's choice of capital structure? Explain.
a. When firm owners borrow money, they have an incentive to engage in excessive risk taking (that is, investing in very risky projects) since they are managing someone else's money.
b. When firms have very limited investment opportunities and little debt financing combined with healthy profits that provide them with free cash flow, their management team might squander the firm's earnings on questionable investments.