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Profit Sharing and Debt Contracts in Presence of Moral Hazard

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  • Nabi, Mahmoud Sami

Abstract

This paper compares profit sharing and debt contracts in presence of moral hazard. Its originality relatively to the existing studies consists in performing the comparison between the two contracts in a more general context. Firstly, the internal funds of the agent (entrepreneur) are enabled to vary between 0% and 99%. Secondly, an incentive mechanism is incorporated to the sharing contract in the context of a two-period relationship. Both contracts are shown to be feasible for sufficiently high internal funds of the entrepreneur. The debt contract is shown to be characterized by larger financial access than the profit sharing contract. In addition, the extension of the financial-relationship to two periods reduces moral hazard and enhances financial access for both contracts, in case of sufficiently foresighted agent and fulfillment of two distinct conditions. For the sharing contract, the additional condition stated an upper bound on the size of the project. For the debt contract, the condition is related to the threat of non-renewal of the financing in case of first-period failure. It is interestingly shown that a more restrictive threat of financing non-renewal improves financial access but lowers the second-period investment. Finally, the paper suggests policy recommendations to enhance financial access without impeding investment through taxation and subsidizing policies.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 49815.

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Date of creation: Mar 2013
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Handle: RePEc:pra:mprapa:49815

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Keywords: Profit sharing; debt contract; moral hazard;

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  1. Joseph E. Stiglitz, 1973. "Incentives and Risk-Sharing in Sharecropping," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 353, Cowles Foundation for Research in Economics, Yale University.
  2. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 52(4), pages 647-63, October.
  3. 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, Elsevier, vol. 50(1), pages 75-89, February.
  4. Innes, Robert D., 1990. "Limited liability and incentive contracting with ex-ante action choices," Journal of Economic Theory, Elsevier, Elsevier, vol. 52(1), pages 45-67, October.
  5. Trester, Jeffrey J., 1998. "Venture capital contracting under asymmetric information," Journal of Banking & Finance, Elsevier, Elsevier, vol. 22(6-8), pages 675-699, August.
  6. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report, Federal Reserve Bank of Minneapolis 45, Federal Reserve Bank of Minneapolis.
  7. Sahlman, William A., 1990. "The structure and governance of venture-capital organizations," Journal of Financial Economics, Elsevier, Elsevier, vol. 27(2), pages 473-521, October.
  8. Admati, Anat R & Pfleiderer, Paul, 1994. " Robust Financial Contracting and the Role of Venture Capitalists," Journal of Finance, American Finance Association, American Finance Association, vol. 49(2), pages 371-402, June.
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