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Moral Hazard and Capital Structure Dynamics

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Author Info
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)

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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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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
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Handle: RePEc:pen:papers:03-006

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

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Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

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    • Aumann, Robert J. & Heifetz, Aviad, 2001. "Incomplete Information," Working Papers 1124, California Institute of Technology, Division of the Humanities and Social Sciences. [Downloadable!]
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Robin Boadway & Jean-Francois Tremblay, 2003. "Public Economics and Startup Entrepreneurs," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  2. Enrico Minelli & Salvatore Modica, 2006. "Credit Market Failures and Policy," Working Papers ubs0607, University of Brescia, Department of Economics. [Downloadable!]
    Other versions:
  3. Dewatripont, Mathias & Legros, Patrick, 2005. "Public-private partnerships: contract design and risk transfer," EIB Papers 5/2005, European Investment Bank, Economic and Financial Studies. [Downloadable!]
  4. Robin Boadway & Oana Secrieru & Marianne Vigneault, 2005. "A Search Model of Venture Capital, Entrepreneurship, and Unemployment," Working Papers 05-24, Bank of Canada. [Downloadable!]
  5. Ohlendorf, Susanne & Schmitz, Patrick W., 2008. "Repeated Moral Hazard, Limited Liability, and Renegotiation," CEPR Discussion Papers 6725, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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