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Costly state verification and optimal investment

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Abstract

We model a lender-borrower relationship in a CSV framework. The project available with the firm is characterized by first-order stochastic dominance. The lender audits the borrower to prevent the latter from strategic default. In this setup, we find the optimal contract is the standard debt contract. However, a debt contract leads to overinvestment. This result is in sharp contrast to those obtained in the literature. The default probability of the project can be influenced by the nature of financial contract in place. The model also derives the relationship between the optimal debt equity ratio and the auditing costs. Copyright Springer 2002

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  • Bappaditya Mukhopadhyay, 2002. "Costly state verification and optimal investment," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 26(3), pages 233-248, September.
    • Handle: RePEc:spr:jecfin:v:26:y:2002:i:3:p:233-248
    DOI: 10.1007/BF02759709
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