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Optimal Debt with Unobservabable Investments

  • Paul Povel

    ()

    (University of Minnesota)

  • Michael Raith

    ()

    (University of Rochester)

We study financial contracting when both an entrepreneur's investment and the resulting revenue are unobservable to an outside investor. We show that a debt contract is always optimal; repayment is induced by a liquidation threat that increases with the extent of default. Moreover, when the entrepreneur's decision concerns the scale of his project, a contract that minimizes liquidation losses is optimal. When the decision concerns managerial effort or project risk, however, it may be optimal to write a contract with a greater threat of liquidation, to induce the entrepreneur to exert more effort or to choose a less risky project.

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Article provided by The RAND Corporation in its journal RAND Journal of Economics.

Volume (Year): 35 (2004)
Issue (Month): 3 (Autumn)
Pages: 599-616

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Handle: RePEc:rje:randje:v:35:y:2004:3:p:599-616
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