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Optimal Debt with Unobservabable Investments

Author

Listed:
  • Paul Povel

    (University of Minnesota)

  • Michael Raith

    (University of Rochester)

Abstract

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.

Suggested Citation

  • Paul Povel & Michael Raith, 2004. "Optimal Debt with Unobservabable Investments," RAND Journal of Economics, The RAND Corporation, vol. 35(3), pages 599-616, Autumn.
    • Handle: RePEc:rje:randje:v:35:y:2004:3:p:599-616
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    Citations

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    Cited by:

    1. Jaideep Chowdhury & Gokhan Sonaer, 2015. "Investment and Managerial Preferences," Economics Bulletin, AccessEcon, vol. 35(1), pages 392-399.
    2. Malcomson James M, 2009. "Principal and Expert Agent," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 9(1), pages 1-36, May.
    3. Boyd, John H. & Hakenes, Hendrik, 2014. "Looting and risk shifting in banking crises," Journal of Economic Theory, Elsevier, vol. 149(C), pages 43-64.
    4. Philipp Meyer-Brauns, 2014. "Financial Contracting with Tax Evaders," Working Papers tax-mpg-rps-2014-01, Max Planck Institute for Tax Law and Public Finance.
    5. Yan Wendy Wu, 2010. "Testing the effects of capital structure on entrepreneurial effort," Applied Financial Economics, Taylor & Francis Journals, vol. 20(10), pages 785-794.
    6. Bolton, Patrick & Oehmke, Martin, 2015. "Should derivatives be privileged in bankruptcy?," LSE Research Online Documents on Economics 84512, London School of Economics and Political Science, LSE Library.
    7. Marta Troya-Martinez, 2013. "Vertical Relational Contracts and Trade Credit," Economics Series Working Papers 648, University of Oxford, Department of Economics.
    8. 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.
    9. Meyer-Brauns, Philipp, 2014. "Financial Contracting with Tax Evaders," VfS Annual Conference 2014 (Hamburg): Evidence-based Economic Policy 100524, Verein für Socialpolitik / German Economic Association.
    10. repec:dau:papers:123456789/2712 is not listed on IDEAS
    11. Mario Tirelli, 2021. "On the optimal investment finance of small businesses," Small Business Economics, Springer, vol. 56(4), pages 1639-1665, April.
    12. Povel, Paul & Raith, Michael, 2004. "Financial constraints and product market competition: ex ante vs. ex post incentives," International Journal of Industrial Organization, Elsevier, vol. 22(7), pages 917-949, September.
    13. HaiYue Liu & ShiYi Liu & JiaTian Li & Peng Wu, 2021. "An empirical study of Chinese listed firms’ herd behaviour in cross‐border mergers and acquisitions," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 61(5), pages 6295-6331, December.
    14. Gui, Zhengqing & von Thadden, Ernst-Ludwig & Zhao, Xiaojian, 2019. "Incentive-compatibility, limited liability and costly liquidation in financial contracting," Games and Economic Behavior, Elsevier, vol. 118(C), pages 412-433.
    15. Yinghui Chen & Xiaolin Gong & Chien-Chi Chu & Yang Cao, 2018. "Access to the Internet and Access to Finance: Theory and Evidence," Sustainability, MDPI, vol. 10(7), pages 1-38, July.

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