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Profit Sharing and Debt Contracts in Presence of Moral Hazard

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  • Nabi, Mahmoud Sami

Abstract

This paper compares profit sharing and debt contracts in presence of moral hazard. Its originality relatively to the existing studies consists in performing the comparison between the two contracts in a more general context. Firstly, the internal funds of the agent (entrepreneur) are enabled to vary between 0% and 99%. Secondly, an incentive mechanism is incorporated to the sharing contract in the context of a two-period relationship. Both contracts are shown to be feasible for sufficiently high internal funds of the entrepreneur. The debt contract is shown to be characterized by larger financial access than the profit sharing contract. In addition, the extension of the financial-relationship to two periods reduces moral hazard and enhances financial access for both contracts, in case of sufficiently foresighted agent and fulfillment of two distinct conditions. For the sharing contract, the additional condition stated an upper bound on the size of the project. For the debt contract, the condition is related to the threat of non-renewal of the financing in case of first-period failure. It is interestingly shown that a more restrictive threat of financing non-renewal improves financial access but lowers the second-period investment. Finally, the paper suggests policy recommendations to enhance financial access without impeding investment through taxation and subsidizing policies.

Suggested Citation

  • Nabi, Mahmoud Sami, 2013. "Profit Sharing and Debt Contracts in Presence of Moral Hazard," MPRA Paper 49815, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:49815
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    References listed on IDEAS

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    Cited by:

    1. Hechem Ajmi & Salina Kassim & Hassanuddeen Abdul Aziz & Walid Mansour, 2019. "A Literature Review of Financial Contracting Theory from the Islamic and Conventional Overviews: Contributions, Gaps, and Perspectives استعراض أدبيات نظرية التعاقد المالي من المنظور الإسلامي والتقليدي," Journal of King Abdulaziz University: Islamic Economics, King Abdulaziz University, Islamic Economics Institute., vol. 32(2), pages 25-42, January.

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    More about this item

    Keywords

    Profit sharing; debt contract; moral hazard;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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