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Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model

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Author Info
PETER M. DeMARZO
YULIY SANNIKOV
Abstract

We derive the optimal dynamic contract in a continuous-time principal-agent setting, and implement it with a capital structure (credit line, long-term debt, and equity) over which the agent controls the payout policy. While the project's volatility and liquidation cost have little impact on the firm's total debt capacity, they increase the use of credit versus debt. Leverage is nonstationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line. Surprisingly, the usual conflicts between debt and equity (asset substitution, strategic default) need not arise. Copyright 2006 by The American Finance Association.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1540-6261.2006.01002.x
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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 61 (2006)
Issue (Month): 6 (December)
Pages: 2681-2724
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Handle: RePEc:bla:jfinan:v:61:y:2006:i:6:p:2681-2724

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  9. Anderson, Ronald W & Carverhill, Andrew, 2007. "Liquidity and Capital Structure," CEPR Discussion Papers 6044, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  11. Rui Albuquerque & Neng Wang, 2007. "Agency Conflicts, Investment, and Asset Pricing," NBER Working Papers 13251, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Mason, Robin & Välimäki, Juuso, 2008. "Dynamic Moral Hazard and Project Completion," CEPR Discussion Papers 6857, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  13. Borys Grochulski, 2008. "Optimal personal bankruptcy design : A Mirrlees approach," Working Paper 08-05, Federal Reserve Bank of Richmond. [Downloadable!]
  14. Dino Gerardi & Lucas Maestri, 2009. "A Principal-Agent Model of Sequential Testing," Levine's Working Paper Archive 814577000000000076, David K. Levine. [Downloadable!]
  15. Alex Edmans & Xavier Gabaix & Tomasz Sadzik & Yuliy Sannikov, 2009. "Dynamic Incentive Accounts," NBER Working Papers 15324, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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