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Moral Hazard and Capital Structure Dynamics

Author

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  • Mathias Dewatripont

    () (Free University of Brussels (VUB/ULB) - European Center for Advanced Research in Economics and Statistics (ECARES))

  • Patrick Legros

    () (Free University of Brussels (VUB/ULB) - European Center for Advanced Research in Economics and Statistics (ECARES))

  • Steven A. Matthews

    () (Department of Economics, University of Pennsylvania)

Abstract

We base a contracting theory for a start-up 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 maximize the entrepreneur’s incentives to exert effort. These contracts are optimal if the entrepreneur 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 non-debt simple contract achieves efficiency — the non-contractibility of effort does not lower welfare. Thus, when the non-contractibility of effort matters, our results mirror typical capital structure dynamics: an early use of debt claims, followed by a switch to equity-like claims.

Suggested Citation

  • Mathias Dewatripont & Patrick Legros & Steven A. Matthews, 2003. "Moral Hazard and Capital Structure Dynamics," PIER Working Paper Archive 03-006, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  • Handle: RePEc:pen:papers:03-006
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    1. Dang, Viet Anh, 2010. "Optimal financial contracts with hidden effort, unobservable profits and endogenous costs of effort," The Quarterly Review of Economics and Finance, Elsevier, vol. 50(1), pages 75-89, February.
    2. Enrico Minelli & Salvatore Modica, 2009. "Credit Market Failures and Policy," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 11(3), pages 363-382, June.
    3. Kadan, Ohad & Swinkels, Jeroen M., 2013. "Minimum payments and induced effort in moral hazard problems," Games and Economic Behavior, Elsevier, vol. 82(C), pages 468-489.
    4. Susanne Ohlendorf & Patrick W. Schmitz, 2012. "Repeated Moral Hazard And Contracts With Memory: The Case Of Risk‐Neutrality," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 53(2), pages 433-452, May.
    5. Valérie Revest & Christophe Le Guehennec, 2007. "Capital risque, intervention publique et marché : le cas des biotechnologies françaises," Working Papers halshs-00200839, HAL.
    6. Berlinger, Edina & Juhász, Péter & Lovas, Anita, 2015. "Az állami támogatás hatása a projektfinanszírozásra erkölcsi kockázat és pozitív externáliák mellett. Szerződéselméleti megközelítés
      [The impact of state subsidy on project financing under moral ha
      ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(2), pages 139-171.
    7. Robin Boadway & Jean-François Tremblay, 2003. "Public Economics and Startup Entrepreneurs," CESifo Working Paper Series 877, CESifo Group Munich.
    8. Ngo Van Long & Antoine Soubeyran & Raphael Soubeyran, 2014. "Knowledge Accumulation Within An Organization," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 55, pages 1089-1128, November.
    9. Valérie Revest & Christophe Le Guehennec, 2007. "Capital risque, intervention publique et marché : le cas des biotechnologies françaises," CEPN Working Papers halshs-00200839, HAL.
    10. Susan Athey, 2002. "Monotone Comparative Statics under Uncertainty," The Quarterly Journal of Economics, Oxford University Press, vol. 117(1), pages 187-223.
    11. Mathias Dewatripont & Patrick Legros, 2005. "Public-private partnerships: contract design and risk transfer," ULB Institutional Repository 2013/175947, ULB -- Universite Libre de Bruxelles.
    12. Jewitt, Ian & Kadan, Ohad & Swinkels, Jeroen M., 2008. "Moral hazard with bounded payments," Journal of Economic Theory, Elsevier, vol. 143(1), pages 59-82, November.
    13. Ingo Fender & Janet Mitchell, 2009. "Incentives and tranche retention in securitisation: a screening model," BIS Working Papers 289, Bank for International Settlements.
    14. Ngo Van Long & Antoine Soubeyran & Raphael Soubeyran, 2014. "Knowledge acquisition within an organization: How to retain a knowledge worker using wage profile and non-monotonic knowledge accumulation," CIRANO Working Papers 2014s-32, CIRANO.
    15. Robin Boadway & Oana Secrieru & Marianne Vigneault, 2005. "A Search Model of Venture Capital, Entrepreneurship, and Unemployment," Staff Working Papers 05-24, Bank of Canada.
    16. Kim, Doyoung & Lawarree, Jacques & Shin, Dongsoo, 2004. "Exit option in hierarchical agency," International Journal of Industrial Organization, Elsevier, vol. 22(8-9), pages 1265-1287, November.
    17. Ohlendorf, Susanne & Schmitz, Patrick W, 2008. "Repeated Moral Hazard, Limited Liability, and Renegotiation," CEPR Discussion Papers 6725, C.E.P.R. Discussion Papers.
    18. Winton, Andrew & Yerramilli, Vijay, 2008. "Entrepreneurial finance: Banks versus venture capital," Journal of Financial Economics, Elsevier, vol. 88(1), pages 51-79, April.
    19. R. Amit & Parthasarathy Ramachandran, 2010. "A Fair Contract for Managing Water Scarcity," Water Resources Management: An International Journal, Published for the European Water Resources Association (EWRA), Springer;European Water Resources Association (EWRA), vol. 24(6), pages 1195-1209, April.
    20. Jean-Étienne Palard, 2007. "Recentrage stratégique et politique de financement:le cas des firmes cotées en Europe (1987-2003)," Revue Finance Contrôle Stratégie, revues.org, vol. 10(3), pages 111-137, September.
    21. Pierre Chaigneau, 2012. "On the Value of Improved Informativeness," Cahiers de recherche 1205, CIRPEE.
    22. Frédéric Blanc-Brude, 2014. "Discussion of Finance and Public-Private Partnerships," RBA Annual Conference Volume (Discontinued),in: Alexandra Heath & Matthew Read (ed.), Financial Flows and Infrastructure Financing Reserve Bank of Australia.

    More about this item

    Keywords

    Moral hazard; renegotiation; convertible debt; capital structure;

    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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