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Informed Lending and Security Design

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  • Inderst, Roman
  • Mueller, Holger

Abstract

We examine the role of security design when lenders make inefficient accept-or-reject decisions after screening projects. Lenders may be either 'too conservative', in which case they reject positive-NPV projects. Or they may be 'too aggressive', in which case they accept negative-NPV projects. In the first case, the uniquely optimal security is debt. In the second case, it is levered equity. Debt maximizes lenders? payoffs from financing low-NPV projects, i.e., projects that have a high probability mass on low cashflows, thus minimizing their conservatism. Conversely, levered equity minimizes lenders? payoffs from financing low-NPV projects, thus minimizing their aggressiveness. In equilibrium, profitable projects that are relatively likely to break even are financed with debt, while less profitable projects are financed with equity. Highly profitable projects are financed by uninformed arm?s-length lenders. Finally, loan terms are insensitive with respect to the screening outcome: borrowers are either accepted, in which case they all obtain the same loan terms, or rejected.

Suggested Citation

  • Inderst, Roman & Mueller, Holger, 2005. "Informed Lending and Security Design," CEPR Discussion Papers 5185, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:5185
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    More about this item

    Keywords

    Security design; Debt; Equity; Screening;
    All these keywords.

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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