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Disputes, debt and equity

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  • Duncan, Alfred J. M.

    (Department of Economics, University of Kent)

  • Nolan, Charles

    (Department of Economics, University of Glasgow)

Abstract

We show how the prospect of disputes over firms' revenue reports promotes debt financing over equity. This is demonstrated in a costly state verification model with a risk averse entrepreneur. The prospect of disputes encourages incentive contracts that limit penalties and avoid stochastic monitoring, even when the lender can commit to stochastic monitoring. Consequently, optimal contracts shift from equity toward standard debt. In short: When audit signals are weakly correlated with true incomes, standard debt contracts emerge as optimal; if audit signals are highly correlated with true incomes, optimal contracts resemble equity. When audit costs are sufficiently high, stochastic monitoring may be optimal. Optimal standard debt contracts under imperfect audits are shown to reproduce key empirical facts of US firm borrowing.

Suggested Citation

  • Duncan, Alfred J. M. & Nolan, Charles, 2019. "Disputes, debt and equity," Theoretical Economics, Econometric Society, vol. 14(3), July.
  • Handle: RePEc:the:publsh:2574
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    Cited by:

    1. Duncan, Alfred J. M. & Nolan, Charles, 2019. "Disputes, debt and equity," Theoretical Economics, Econometric Society, vol. 14(3), July.
    2. Le, Vo Phuong Mai & Meenagh, David & Minford, Patrick, 2016. "Monetarism rides again? US monetary policy in a world of Quantitative Easing," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 44(C), pages 85-102.
    3. Alfred Duncan & Charles Nolan, 2015. "Objectives and Challenges of Macroprudential Policy," Working Papers 2015_22, Business School - Economics, University of Glasgow.
    4. Alfred Duncan & Charles Nolan, 2017. "Financial Frictions in Macroeconomic Models," Studies in Economics 1719, School of Economics, University of Kent.

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    More about this item

    Keywords

    Microeconomics; costly state verification; external finance; leverage;
    All these keywords.

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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