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Optimal Financial Contracting and the Effects of Firm's Size

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  • Sandro Brusco
  • Giuseppe Lopomo
  • Eva Ropero
  • Alessandro T. Villa

Abstract

We consider the design of optimal dynamic financing for a firm subject to moral hazard problems. With respect to the existing literature we enrich the model by introducing durable capital. The existence of durable capital allows us to analyze the role of firm's size, separately from age and financial structure. We find that a higher level of capital decreases the probability of liquidation, increases future size and reduces the average return and volatility on the assets of the firm. Although analytical results are not available, we show through simulations that the rate of growth of capital is decreasing with size and that its variability first increases with size and eventually it declines. These results are broadly in agreement with the empirical results on the effects of firm size.

Suggested Citation

  • Sandro Brusco & Giuseppe Lopomo & Eva Ropero & Alessandro T. Villa, 2018. "Optimal Financial Contracting and the Effects of Firm's Size," Department of Economics Working Papers 18-13, Stony Brook University, Department of Economics.
  • Handle: RePEc:nys:sunysb:18-13
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    File URL: https://www.stonybrook.edu/commcms/economics/research/papers/2018/ContractingAndFirmSize_1813.pdf
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    References listed on IDEAS

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    1. Thomas Cooley & Ramon Marimon & Vincenzo Quadrini, 2004. "Aggregate Consequences of Limited Contract Enforceability," Journal of Political Economy, University of Chicago Press, vol. 112(4), pages 817-847, August.
    2. Andrea Lanteri, 2018. "The Market for Used Capital: Endogenous Irreversibility and Reallocation over the Business Cycle," American Economic Review, American Economic Association, vol. 108(9), pages 2383-2419, September.
    3. Evans, David S, 1987. "The Relationship between Firm Growth, Size, and Age: Estimates for 100 Manufacturing Industries," Journal of Industrial Economics, Wiley Blackwell, vol. 35(4), pages 567-581, June.
    4. Patrick Bolton & Hui Chen & Neng Wang, 2011. "A Unified Theory of Tobin's q, Corporate Investment, Financing, and Risk Management," Journal of Finance, American Finance Association, vol. 66(5), pages 1545-1578, October.
    5. Peter M. DeMarzo & Michael J. Fishman, 2007. "Agency and Optimal Investment Dynamics," Review of Financial Studies, Society for Financial Studies, vol. 20(1), pages 151-188, January.
    6. Gian Luca Clementi & Hugo A. Hopenhayn, 2006. "A Theory of Financing Constraints and Firm Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 121(1), pages 229-265.
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