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Financing and Corporate Growth under Repeated Moral Hazard

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  • Ron Anderson

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  • Kjell G. Nyborg

Abstract

This paper considers the impact of financial contracting on growth by exploring a model where entrepreneurs initially do R&D but subsequently need both outside investors to provide funds for capital investments and outside mangers to operate the firm efficiently some time after assets are in place. The source of contracting inefficiency is that insiders can divert cash flows for their own benefit. We employ a repeated games framework which allows us to model outside equity as well as inside equity and debt. We call our framework the two-stage model of firm growth. A key finding is that outside equity promotes ex post efficiently (second stage growth) at the expense of ex ante efficiently (first stage growth) which debt work the opposite way. This is because equity promotes replacement of the entrepreneur, while debt promotes entrenchment. So debt has the disadvantage that it is less conducive to the implementation of second stage growth than equity, but the advantage that it provides the entrepreneur with more incentives to do R&D in the first place. Furthermore, equity is fragile, in the sense that moral hazard may be so high that investors will not finance the firm, regardless of the discount rate. In contrast, debt financing definitely can be raised for low discount rates. a prediciton of the model is that in a cross-section of firms, we should observe a preponderance of high levered, closely-held firms which have stagnated after an early growth phase.

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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp376.

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Date of creation: Apr 2001
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Handle: RePEc:fmg:fmgdps:dp376

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Citations

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Cited by:
  1. Ronald W. Anderson & Kjell G. Nyborg, 2001. "Financial development, agency and the pace of adoption of new techniques," LSE Research Online Documents on Economics 25065, London School of Economics and Political Science, LSE Library.
  2. Ronald W. Anderson & Maria Cecilia Bustamante & Stéphane Guibaud, 2012. "Agency, firm growth, and managerial turnover," LSE Research Online Documents on Economics 43144, London School of Economics and Political Science, LSE Library.
  3. Julia Hirsch & Uwe Walz, 2009. "Financing Decisions Along a Firm’s Life Cycle: Debt as a Commitment Device," Working Papers 0409, Universidad Iberoamericana, Department of Economics.
  4. Hans K. Hvide & Tore Leite, 2003. "A Theory of Capital Structure with Strategic Defaults and Priority Violations," Finance 0311003, EconWPA.
  5. Ronald W. Anderson & Kjell G. Nyborg, 2002. "Agency and the Pace of Adoption of New Techniques," Recherches économiques de Louvain, De Boeck Université, vol. 68(1), pages 203-220.
  6. Ronald W. Anderson & M. Cecilia Bustamante & Stéphane Guibaud, 2012. "Agency, Firm Growth, and Managerial Turnover," FMG Discussion Papers dp711, Financial Markets Group.
  7. Elisabeth Mueller, 2008. "Benefits of control, capital structure and company growth," Applied Economics, Taylor & Francis Journals, vol. 40(21), pages 2721-2734.
  8. Timothy Fogarty & Michel Magnan & Garen Markarian & Serge Bohdjalian, 2009. "Inside Agency: The Rise and Fall of Nortel," Journal of Business Ethics, Springer, vol. 84(2), pages 165-187, January.

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