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Moral Hazard and Capital Structure Dynamics

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  • Mathias Dewatripont

    (ECARES, Université Libre de Bruxelles, and CEPR)

  • Patrick Legros

    (ECARES, Université Libre de Bruxelles, and CEPR)

  • Steven A. Matthews

    (University of Pennsylvania)

Abstract

We base a contracting theory for a startup firm on an agency model with observable but nonverifiable effort, and renegotiable contracts. Two essential restrictions on simple contracts are imposed: the entrepreneur must be given limited liability, and the investor's earnings must not decrease in the realized profit of the firm. All message game contracts with pure strategy equilibria (and no third parties) are considered. Within this class of contracts/equilibria, and regardless of who has the renegotiating bargaining power, debt and convertible debt maxi-mize the entrepreneur's incentives to exert effort. These contracts are optimal if the entre-preneur has the bargaining power in renegotiation. If the investor has the bargaining power, the same is true unless debt induces excessive effort. In the latter case, a nondebt simple contract achieves efficiency-the noncontractibility of effort does not lower welfare. Thus, when the noncontractibility of effort matters, our results mirror typical capital structure dynamics: an early use of debt claims, followed by a switch to equity-like claims. (JEL: D820, L140, O261) Copyright (c) 2003 The European Economic Association.

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Bibliographic Info

Article provided by MIT Press in its journal Journal of the European Economic Association.

Volume (Year): 1 (2003)
Issue (Month): 4 (06)
Pages: 890-930

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Handle: RePEc:tpr:jeurec:v:1:y:2003:i:4:p:890-930

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Cited by:
  1. Ingo Fender & Janet Mitchell, 2009. "Incentives and tranche retention in securitisation: a screening model," BIS Working Papers 289, Bank for International Settlements.
  2. R. Amit & Parthasarathy Ramachandran, 2010. "A Fair Contract for Managing Water Scarcity," Water Resources Management, Springer, vol. 24(6), pages 1195-1209, April.
  3. Ohlendorf, Susanne & Schmitz, Patrick W., 2011. "Repeated moral hazard and contracts with memory: The case of risk-neutrality," MPRA Paper 28823, University Library of Munich, Germany.
  4. Winton, Andrew & Yerramilli, Vijay, 2008. "Entrepreneurial finance: Banks versus venture capital," Journal of Financial Economics, Elsevier, vol. 88(1), pages 51-79, April.
  5. MINELLI, Enrico & MODICA, Salvatore, 2003. "Credit market failures and policy," CORE Discussion Papers 2003093, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  6. repec:hal:wpaper:halshs-00200839 is not listed on IDEAS
  7. Robin Boadway & Oana Secrieru & Marianne Vigneault, 2005. "A Search Model of Venture Capital, Entrepreneurship, and Unemployment," Working Papers 05-24, Bank of Canada.
  8. Pierre Chaigneau, 2012. "On the Value of Improved Informativeness," Cahiers de recherche 1205, CIRPEE.
  9. Athey, Susan, 2002. "Monotone Comparative Statics Under Uncertainty," Scholarly Articles 3372263, Harvard University Department of Economics.
  10. repec:hal:cepnwp:halshs-00200839 is not listed on IDEAS
  11. Doyoung Kim & Jacques Lawarree & Dongsoo Shin, 2004. "Exit Option in Hierarchical Agency," Econometric Society 2004 North American Winter Meetings 269, Econometric Society.
  12. Dang, Viet Anh, 2010. "Optimal financial contracts with hidden effort, unobservable profits and endogenous costs of effort," The Quarterly Review of Economics and Finance, Elsevier, vol. 50(1), pages 75-89, February.
  13. Robin Boadway & Jean-François Tremblay, 2003. "Public Economics and Startup Entrepreneurs," CESifo Working Paper Series 877, CESifo Group Munich.
  14. Kadan, Ohad & Swinkels, Jeroen M., 2013. "Minimum payments and induced effort in moral hazard problems," Games and Economic Behavior, Elsevier, vol. 82(C), pages 468-489.
  15. Jean-Étienne Palard, 2007. "Recentrage stratégique et politique de financement:le cas des firmes cotées en Europe (1987-2003)," Revue Finance Contrôle Stratégie, revues.org, vol. 10(3), pages 111-137, September.
  16. Ngo Van Long & Antoine Soubeyran & Raphael Soubeyran, 2012. "Knowledge Accumulation within an Organization," Working Papers 12-03, LAMETA, Universtiy of Montpellier, revised Jan 2012.
  17. Ohlendorf, Susanne & Schmitz, Patrick W., 2008. "Repeated Moral Hazard, Limited Liability, and Renegotiation," CEPR Discussion Papers 6725, C.E.P.R. Discussion Papers.
  18. Dewatripont, Mathias & Legros, Patrick, 2005. "Public-private partnerships: contract design and risk transfer," EIB Papers 5/2005, European Investment Bank, Economics Department.
  19. Jewitt, Ian & Kadan, Ohad & Swinkels, Jeroen M., 2008. "Moral hazard with bounded payments," Journal of Economic Theory, Elsevier, vol. 143(1), pages 59-82, November.

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