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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)

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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Bibliographic 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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Cited by:
  1. James Malcomson, 2004. "Principal and Expert Agent," Economics Series Working Papers 193, University of Oxford, Department of Economics.
  2. Challe, Edouard & Ragot, Xavier, . "Risk Shifting, Asset Bubbles, and Self-fulfilling Crises," Open Access publications from Université Paris-Dauphine urn:hdl:123456789/2712, Université Paris-Dauphine.
  3. Hans K. Hvide & Todd Kaplan, 2003. "A Theory of Capital Structure with Strategic Defaults and Priority Violations," Microeconomics 0311001, EconWPA.
  4. 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.
  5. Marta Troya-Martinez, 2013. "Vertical Relational Contracts and Trade Credit," Economics Series Working Papers 648, University of Oxford, Department of Economics.
  6. Alan Schwartz, . "A Normative Theory of Business Bankruptcy," American Law & Economics Association Annual Meetings 1037, American Law & Economics Association.
  7. Povel, Paul & Raith, Michael, 2004. "Financial constraints and product market competition: ex ante vs. ex post incentives," International Journal of Industrial Organization, Elsevier, vol. 22(7), pages 917-949, September.

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