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Costly state verification and optimal investment

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Abstract

We model a lender-borrower relationship in a CSV framework. The project available with the firm is characterized by first-order stochastic dominance. The lender audits the borrower to prevent the latter from strategic default. In this setup, we find the optimal contract is the standard debt contract. However, a debt contract leads to overinvestment. This result is in sharp contrast to those obtained in the literature. The default probability of the project can be influenced by the nature of financial contract in place. The model also derives the relationship between the optimal debt equity ratio and the auditing costs. Copyright Springer 2002

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  • Bappaditya Mukhopadhyay, 2002. "Costly state verification and optimal investment," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 26(3), pages 233-248, September.
    • Handle: RePEc:spr:jecfin:v:26:y:2002:i:3:p:233-248
    DOI: 10.1007/BF02759709
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    1. Narayanan, M. P., 1988. "Debt versus Equity under Asymmetric Information," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(1), pages 39-51, March.
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    4. Douglas Gale & Martin Hellwig, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 52(4), pages 647-663.
    5. David de Meza & David C. Webb, 1987. "Too Much Investment: A Problem of Asymmetric Information," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 102(2), pages 281-292.
    6. Moore, Robert R, 1993. "Asymmetric Information, Repeated Lending, and Capital Structure," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 25(3), pages 393-409, August.
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