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Limited Liability and Option Contracts in Models with Sequential Investments

  • Christoph Lülfesmann

The paper investigates a model where two parties sequentially invest in a joint project (an asset). Investments and the project value are unverifiable, and A is wealth constrained so that an initial outlay must be financed by either agent B or an external investor C, say a bank. We show that an option contract in combination with a loan arrangement facilitates first best investments and any distribution of surplus if renegotiation is infeasible. Moreover, the optimal strike price of the option is shown to differ across financing modes. If renegotiation is admitted, the first best can still be attained unless A's bargaining position is too strong. Otherwise, B financing or C financing may become strictly preferable, and a combination of multiple lenders may be optimal.

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Paper provided by University of Bonn, Germany in its series Bonn Econ Discussion Papers with number bgse27_2001.

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Length: 28
Date of creation: Jul 2001
Date of revision:
Handle: RePEc:bon:bonedp:bgse27_2001
Contact details of provider: Postal: Bonn Graduate School of Economics, University of Bonn, Adenauerallee 24 - 26, 53113 Bonn, Germany
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  1. Joel S. Demski & David E.M. Sappington, 1991. "Resolving Double Moral Hazard Problems with Buyout Agreements," RAND Journal of Economics, The RAND Corporation, vol. 22(2), pages 232-240, Summer.
  2. Klaus M. Schmidt, 2003. "Convertible Securities and Venture Capital Finance," Journal of Finance, American Finance Association, vol. 58(3), pages 1139-1166, 06.
  3. Arora, Ashish & Gambardella, Alfonso, 1990. "Complementarity and External Linkages: The Strategies of the Large Firms in Biotechnology," Journal of Industrial Economics, Wiley Blackwell, vol. 38(4), pages 361-79, June.
  4. Aghion, P. & Tirole, J., 1993. "On the Management of Innovation," Working papers 93-12, Massachusetts Institute of Technology (MIT), Department of Economics.
  5. Edlin, Aaron S & Hermalin, Benjamin E, 2000. "Contract Renegotiation and Options in Agency Problems," Journal of Law, Economics and Organization, Oxford University Press, vol. 16(2), pages 395-423, October.
  6. Nöldeke, Georg & Schmidt, Klaus M., 1998. "Sequential investments and options to own," Munich Reprints in Economics 19327, University of Munich, Department of Economics.
  7. Oliver Hart & John Moore, 1994. "Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management," NBER Working Papers 4886, National Bureau of Economic Research, Inc.
  8. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February.
  9. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, vol. 80(1), pages 93-106, March.
  10. Hagedoorn, John & Link, Albert N. & Vonortas, Nicholas S., 2000. "Research partnerships1," Research Policy, Elsevier, vol. 29(4-5), pages 567-586, April.
  11. repec:tpr:qjecon:v:109:y:1994:i:4:p:1185-1209 is not listed on IDEAS
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