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Optimal Debt with Unobservabable Investments

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Author Info
Paul Povel () (University of Minnesota)
Michael Raith () (University of Rochester)

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Abstract

We study financial contracting when both an entrepreneur's investment and the resulting revenue are unobservable to an outside investor. We show that a debt contract is always optimal; repayment is induced by a liquidation threat that increases with the extent of default. Moreover, when the entrepreneur's decision concerns the scale of his project, a contract that minimizes liquidation losses is optimal. When the decision concerns managerial effort or project risk, however, it may be optimal to write a contract with a greater threat of liquidation, to induce the entrepreneur to exert more effort or to choose a less risky project.

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Publisher Info
Article provided by The RAND Corporation in its journal RAND Journal of Economics.

Volume (Year): 35 (2004)
Issue (Month): 3 (Autumn)
Pages: 599-616
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Handle: RePEc:rje:randje:v:35:y:2004:3:p:599-616

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  1. Cleary, Sean & Povel, Paul E M & Raith, Michael, 2004. "The U-Shaped Investment Curve: Theory and Evidence," CEPR Discussion Papers 4206, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  2. James Malcomson, 2004. "Principal and Expert Agent," Economics Series Working Papers 193, University of Oxford, Department of Economics. [Downloadable!]
    Other versions:
  3. Alan Schwartz, . "A Normative Theory of Business Bankruptcy," American Law & Economics Association Annual Meetings 1037, American Law & Economics Association. [Downloadable!]
  4. Hans K. Hvide & Todd Kaplan, 2003. "A Theory of Capital Structure with Strategic Defaults and Priority Violations," Microeconomics 0311001, EconWPA. [Downloadable!]
    Other versions:
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This page was last updated on 2009-12-9.


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