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Self-Enforcing Stochastic Monitoring and the Separation of Debt and Equity Claims

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  • Harold L. Cole

Abstract

This paper studies the incentive issues associated with self-enforcing stochastic monitoring in a model of investment and production. The efficient contract features a debt-like payment with a threshold in terms of the reported output in which all of the reported output is taken up to the threshold if monitoring doesn't occur and all of the output is taken if monitoring does occur. An output report above the threshold leads to zero probability of monitoring and just the threshold amount being paid out. The efficiency gap between the self-enforcing contract and the commitment constraint is minimized when the monitors hold no part of the residual claim on the firm, which we associate with equity. Misreporting by the manager is an important component of the efficient contract.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14480.

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Date of creation: Nov 2008
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Handle: RePEc:nbr:nberwo:14480

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  1. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," STICERD - Theoretical Economics Paper Series /1997/321, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  2. Dewatripont, Mathias & Tirole, Jean, 1994. "A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 1027-54, November.
  3. Monnet, Cyril & Quintin, Erwan, 2002. "Optimal contracts in a dynamic costly state verification model," Working Paper Series 0126, European Central Bank.
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  7. Stephen D. Williamson, 1984. "Costly Monitoring, Loan Contracts and Equilibrium Credit Rationing," Working Papers 572, Queen's University, Department of Economics.
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  13. Simi Kedia & Thomas Philippon, 2005. "The Economics of Fraudulent Accounting," NBER Working Papers 11573, National Bureau of Economic Research, Inc.
  14. Erik Berglof & Ernst-Ludwig von Thadden, 1994. "Capital Structure with Multiple Investors," CEPR Financial Markets Paper 0044, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
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  16. Mookherjee, Dilip & Png, Ivan, 1989. "Optimal Auditing, Insurance, and Redistribution," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 399-415, May.
  17. Bester, Helmut & Strausz, Roland, 2001. "Contracting with Imperfect Commitment and the Revelation Principle: The Single Agent Case," Econometrica, Econometric Society, vol. 69(4), pages 1077-98, July.
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  1. Economists Becoming more Clueless
    by Eric Falkenstein in Falkenblog on 2010-03-25 01:16:00

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