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Incentive-Compatibility, Limited Liability and Costly Liquidation in Financial Contracting

Author

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  • Zhengqing Gui

  • Ernst-Ludwig von Thadden

  • Xiaojian Zhao

Abstract

We characterize an optimal financial contract when the firm’s realized cash flow is unobservable to the investor and the firm’s collateral can only be liquidated partially by resorting to the services of a costly third party. An optimal contract may exhibit a piecewise structure and vary with the liquidation cost and the firm’s actual liquidity shortage. Partial liquidation and wholesale transfers of collateral can coexist in an optimal contract. In contrast to part of the literature, the incentive-compatibility constraint incorporates the firm’s limited liability, and may be slack at the optimum. Allowing the firm to overcome an ex-post liquidity shortage by borrowing surreptitiously from a third party may reduce the firm’s ex-ante expected utility.

Suggested Citation

  • Zhengqing Gui & Ernst-Ludwig von Thadden & Xiaojian Zhao, 2018. "Incentive-Compatibility, Limited Liability and Costly Liquidation in Financial Contracting," CRC TR 224 Discussion Paper Series crctr224_2018_064, University of Bonn and University of Mannheim, Germany.
    • Handle: RePEc:bon:boncrc:crctr224_2018_064
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    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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