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The use of debt and equity in optimal financial contracts

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  • John H. Boyd
  • Bruce D. Smith

Abstract

We consider an environment in which risk-neutral firms must obtain external finance. They have access to two kinds of linear, stochastic investment opportunities. For one, return realizations are costlessly observed by all agents. For the other, return realizations are costlessly observed only by the investing firm; however, they can be (privately) observed by outsiders who bear a fixed verification cost. Thus, the second investment opportunity is subject to a standard costly state verification (CSV) problem of the type considered by Townsend (1979), Gale and Hellwig (1985), or Williamson (1986, 1987). ; We examine the optimal allocations of investment between the two kinds of projects, as well as the optimal contract used to finance it. We show that the optimal contractual outcome can be supported by having firms issue appropriate (and determinate) quantities of debt and equity securities to outside investors. ; The optimal debt-equity ratio necessarily depends (in part) on the firm's asset structure. Investments in projects subject to CSV problems are associated (in a sense to be made precise) with the use of debt - as might be expected from the existing CSV literature. Investments in projects with publicly observable returns are associated with the use of external equity. ; We examine in detail the relationship between the optimal asset and liability structure of the firm. We also describe conditions under which an increase in the cost of state verification shifts the composition of investment towards projects with observable returns, and reduces the optimal debt-equity ratio. Interestingly, the optimal debt-equity ratio is also shown to depend on factors that are irrelevant to asset allocations. ; Finally, a large part of the interest in CSV environments has been due to the fact that they may result in equilibrium credit rationing. Our analysis has strong implications for the possibility of equilibrium credit rationing in more general CSV models.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Minneapolis in its series Working Papers with number 537.

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Date of creation: 1996
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Publication status: Published in Journal of Financial Intermediation (Vol. 8, No. 4, October 1999, pp. 270-316)
Handle: RePEc:fip:fedmwp:537

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Keywords: Debt ; Equity;

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References

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  1. Levine, Ross, 1991. " Stock Markets, Growth, and Tax Policy," Journal of Finance, American Finance Association, vol. 46(4), pages 1445-65, September.
  2. Jensen, Michael C & Murphy, Kevin J, 1990. "Performance Pay and Top-Management Incentives," Journal of Political Economy, University of Chicago Press, vol. 98(2), pages 225-64, April.
  3. Bencivenga, V.R. & Smith, B.D., 1988. "Financial Intermediation And Endogenous Growth," RCER Working Papers 124, University of Rochester - Center for Economic Research (RCER).
  4. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  5. Boyd, John H. & Prescott, Edward C., 1986. "Financial intermediary-coalitions," Journal of Economic Theory, Elsevier, vol. 38(2), pages 211-232, April.
  6. Bruce D. Smith & John H. Boyd, 1998. "The evolution of debt and equity markets in economic development," Economic Theory, Springer, vol. 12(3), pages 519-560.
  7. John H. Boyd & Bruce D. Smith, 1996. "The co-evolution of the real and financial sectors in the growth process," Working Papers 541, Federal Reserve Bank of Minneapolis.
  8. Stephen D. Williamson, 1984. "Costly Monitoring, Loan Contracts and Equilibrium Credit Rationing," Working Papers 572, Queen's University, Department of Economics.
  9. Boyd, John H. & Smith, Bruce D., 1997. "Capital Market Imperfections, International Credit Markets, and Nonconvergence," Journal of Economic Theory, Elsevier, vol. 73(2), pages 335-364, April.
  10. Boyd, John H. & Smith, Bruce D., 1992. "Intermediation and the equilibrium allocation of investment capital : Implications for economic development," Journal of Monetary Economics, Elsevier, vol. 30(3), pages 409-432, December.
  11. Boyd, John H & Smith, Bruce D, 1994. "How Good Are Standard Debt Contracts? Stochastic versus Nonstochastic Monitoring in a Costly State Verification Environment," The Journal of Business, University of Chicago Press, vol. 67(4), pages 539-61, October.
  12. Bruce D. Smith & Cheng Wang, 1997. "Repeated insurance relationships in a costly state verification model: with an application to deposit insurance," Working Papers 574, Federal Reserve Bank of Minneapolis.
  13. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  14. Arnoud W A Boot & Anjan V Thakor, 1992. "Security Design," CEPR Financial Markets Paper 0020, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
  15. Seward, James K, 1990. " Corporate Financial Policy and the Theory of Financial Intermediation," Journal of Finance, American Finance Association, vol. 45(2), pages 351-77, June.
  16. Bruce D. Smith & John H. Boyd, 1998. "Capital market imperfections in a monetary growth model," Economic Theory, Springer, vol. 11(2), pages 241-273.
  17. Fluck, Zsuzsanna, 1998. "Optimal Financial Contracting: Debt versus Outside Equity," Review of Financial Studies, Society for Financial Studies, vol. 11(2), pages 383-418.
  18. Boyd, J.h. & Smith, B.D., 1991. "The Equilibrium Allocation of Investment Capital in the Presence of Adverse Selection and Costly State Verification," RCER Working Papers 289, University of Rochester - Center for Economic Research (RCER).
  19. Stephen D. Williamson, 1984. "Costly Monitoring, Financial Intermediation, and Equilibrium Credit Rationing," Working Papers 583, Queen's University, Department of Economics.
  20. Besanko, David & Thakor, Anjan V, 1987. "Collateral and Rationing: Sorting Equilibria in Monopolistic and Competitive Credit Markets," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 671-89, October.
  21. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
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Citations

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Cited by:
  1. Pedro Elosegui & Anne P. Villamil, 2007. "Risky Banking and Credit Rationing," BCRA Working Paper Series 200720, Central Bank of Argentina, Economic Research Department.
  2. Fahad Khalil & Bruno Parigi & David Martimort, 2007. "Monitoring a Common Agent: implications for financial contracting," Working Papers UWEC-2003-04-P, University of Washington, Department of Economics.
  3. Mark M. Spiegel, 2000. "Solvency runs, sunspot runs, and international bailouts," Working Paper Series 2001-05, Federal Reserve Bank of San Francisco.
  4. repec:fip:fedfap:2001-05 is not listed on IDEAS
  5. Hans K. Hvide & Tore Leite, 2003. "A Theory of Capital Structure with Strategic Defaults and Priority Violations," Finance 0311003, EconWPA.
  6. Attar, Andrea & Campioni, Eloisa, 2003. "Costly state verification and debt contracts: a critical resume," Research in Economics, Elsevier, vol. 57(4), pages 315-343, December.
  7. Elosegui, Pedro Luis, 2003. "Aggregate risk, credit rationing and capital accumulation," The Quarterly Review of Economics and Finance, Elsevier, vol. 43(4), pages 668-696.
  8. ATTAR, Andréa, 2003. "Financial contracting along the business cycle," CORE Discussion Papers 2003069, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  9. Boyd, John H. & Hakenes, Hendrik, 2014. "Looting and risk shifting in banking crises," Journal of Economic Theory, Elsevier, vol. 149(C), pages 43-64.
  10. Albertazzi, Ugo & Gambacorta, Leonardo, 2009. "Bank profitability and the business cycle," Journal of Financial Stability, Elsevier, vol. 5(4), pages 393-409, December.
  11. Persons, John C., 1997. "Liars Never Prosper? How Management Misrepresentation Reduces Monitoring Costs," Journal of Financial Intermediation, Elsevier, vol. 6(4), pages 269-306, October.

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