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Moral Hazard and Capital Structure Dynamics

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  • Mathias Dewatripont

    ()
    (Free University of Brussels (VUB/ULB) - European Center for Advanced Research in Economics and Statistics (ECARES))

  • Patrick Legros

    ()
    (Free University of Brussels (VUB/ULB) - European Center for Advanced Research in Economics and Statistics (ECARES))

  • Steven A. Matthews

    ()
    (Department of Economics, University of Pennsylvania)

Abstract

We base a contracting theory for a start-up 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 maximize the entrepreneur’s incentives to exert effort. These contracts are optimal if the entrepreneur 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 non-debt simple contract achieves efficiency — the non-contractibility of effort does not lower welfare. Thus, when the non-contractibility of effort matters, our results mirror typical capital structure dynamics: an early use of debt claims, followed by a switch to equity-like claims.

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Bibliographic Info

Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 03-006.

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Length: 53 pages
Date of creation: 29 Jan 2003
Date of revision:
Handle: RePEc:pen:papers:03-006

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Keywords: Moral hazard; renegotiation; convertible debt; capital structure;

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References

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Citations

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Cited by:
  1. Robin Boadway & Jean-François Tremblay, 2003. "Public Economics and Startup Entrepreneurs," CESifo Working Paper Series 877, CESifo Group Munich.
  2. repec:hal:cepnwp:halshs-00200839 is not listed on IDEAS
  3. Athey, Susan, 2002. "Monotone Comparative Statics Under Uncertainty," Scholarly Articles 3372263, Harvard University Department of Economics.
  4. 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.
  5. repec:hal:wpaper:halshs-00200839 is not listed on IDEAS
  6. Ingo Fender & Janet Mitchell, 2009. "Incentives and tranche retention in securitisation: a screening model," BIS Working Papers 289, Bank for International Settlements.
  7. 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).
  8. Doyoung Kim & Jacques Lawarree & Dongsoo Shin, 2004. "Exit Option in Hierarchical Agency," Econometric Society 2004 North American Winter Meetings 269, Econometric Society.
  9. Pierre Chaigneau, 2012. "On the Value of Improved Informativeness," Cahiers de recherche 1205, CIRPEE.
  10. Ohlendorf, Susanne & Schmitz, Patrick W., 2008. "Repeated Moral Hazard, Limited Liability, and Renegotiation," CEPR Discussion Papers 6725, C.E.P.R. Discussion Papers.
  11. Ngo Van Long & Antoine Soubeyran & Raphael Soubeyran, 2012. "Knowledge Accumulation within an Organization," Working Papers 12-03, LAMETA, Universtiy of Montpellier, revised Jan 2012.
  12. Robin Boadway & Oana Secrieru & Marianne Vigneault, 2005. "A Search Model of Venture Capital, Entrepreneurship, and Unemployment," Working Papers 05-24, Bank of Canada.
  13. 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.
  14. 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.
  15. Susanne Ohlendorf & Patrick W. Schmitz, 2012. "Repeated Moral Hazard And Contracts With Memory: The Case Of Risk‐Neutrality," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 53(2), pages 433-452, 05.
  16. Dewatripont, Mathias & Legros, Patrick, 2005. "Public-private partnerships: contract design and risk transfer," EIB Papers 5/2005, European Investment Bank, Economics Department.
  17. Winton, Andrew & Yerramilli, Vijay, 2008. "Entrepreneurial finance: Banks versus venture capital," Journal of Financial Economics, Elsevier, vol. 88(1), pages 51-79, April.
  18. 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.

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