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Moral Hazard and Capital Structure Dynamics

Author

Listed:
  • Mathias Dewatripont

    (ECARES, Université Libre de Bruxelles, and CEPR)

  • Patrick Legros

    (ECARES, Université Libre de Bruxelles, and CEPR)

  • Steven A. Matthews

    (University of Pennsylvania)

Abstract

We base a contracting theory for a startup firm on an agency model with observable but nonverifiable effort, and renegotiable contracts. Two essential restrictions on simple contracts are imposed: the entrepreneur must be given limited liability, and the investor's earnings must not decrease in the realized profit of the firm. All message game contracts with pure strategy equilibria (and no third parties) are considered. Within this class of contracts/equilibria, and regardless of who has the renegotiating bargaining power, debt and convertible debt maxi-mize the entrepreneur's incentives to exert effort. These contracts are optimal if the entre-preneur has the bargaining power in renegotiation. If the investor has the bargaining power, the same is true unless debt induces excessive effort. In the latter case, a nondebt simple contract achieves efficiency-the noncontractibility of effort does not lower welfare. Thus, when the noncontractibility of effort matters, our results mirror typical capital structure dynamics: an early use of debt claims, followed by a switch to equity-like claims. (JEL: D820, L140, O261) Copyright (c) 2003 The European Economic Association.

Suggested Citation

  • Mathias Dewatripont & Patrick Legros & Steven A. Matthews, 2003. "Moral Hazard and Capital Structure Dynamics," Journal of the European Economic Association, MIT Press, vol. 1(4), pages 890-930, June.
    • Handle: RePEc:tpr:jeurec:v:1:y:2003:i:4:p:890-930
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    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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