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Access to Finance and Investment: Does Profit Sharing Dominate Debt?

Listed author(s):
  • Nabi, Mahmoud Sami

    (The Islamic Research and Teaching Institute (IRTI))

This paper compares sharing (equity) and debt contracts in presence of moral hazard which manifests as the hidden effort undertaken by the entrepreneur. The originality of this paper relatively to the existing studies consists in performing the comparison between the two types of contracts while considering a more general context along two dimensions. The first dimension is enabling the internal funds of the entrepreneur to vary between 0% and a level just inferior to 100%. The second dimension is the incorporation of an incentive mechanism to the sharing contract in the context of a two‐period relationship. I showed that the sharing and debt contracts are feasible when the internal funds of the entrepreneur are superior to determined thresholds. These thresholds depend on the characteristics of the project (size, payoffs, and probability of success/failure) and the opportunity cost of the financier. The debt contract is shown to be characterized by larger financial access than the sharing contract. I have also shown that the enlargement of the financial‐relationship to two periods has an incentivizing effect on the entrepreneur and enlarges the region of financial access for the two types of contracts, if a common condition of sufficiently foresighted entrepreneur is satisfied. However, two distinct conditions are also necessary for the enlargement of the financial access to occur. For the sharing contract, the second condition is related to the size of the project which should be inferior to a determined threshold. For the debt contract, the second condition is related to the threat of non‐renewal of the financing in case of first‐period failure, which should be sufficiently stringent. In addition, it has been shown that the more restrictive the threat of non‐renewal the larger the region of financial access. However, this is realized at the expense of the second period investment which decreases, and represents the economic efficiency’ effect of the debt contract. Finally, I discussed the effect on the financial access of taxing the “risk‐free” financial operation and subsidizing the “higher effort” of the insufficiently‐capitalized entrepreneurs.

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Paper provided by The Islamic Research and Teaching Institute (IRTI) in its series Working Papers with number 0000-0.

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Length: 40 pages
Date of creation: Jan 1437
Handle: RePEc:ris:irtiwp:0000_000
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  1. Joseph E. Stiglitz, 1974. "Incentives and Risk Sharing in Sharecropping," Review of Economic Studies, Oxford University Press, vol. 41(2), pages 219-255.
  2. Admati, Anat R & Pfleiderer, Paul, 1994. " Robust Financial Contracting and the Role of Venture Capitalists," Journal of Finance, American Finance Association, vol. 49(2), pages 371-402, June.
  3. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  4. Innes, Robert D., 1990. "Limited liability and incentive contracting with ex-ante action choices," Journal of Economic Theory, Elsevier, vol. 52(1), pages 45-67, October.
  5. Trester, Jeffrey J., 1998. "Venture capital contracting under asymmetric information," Journal of Banking & Finance, Elsevier, vol. 22(6-8), pages 675-699, August.
  6. Siddiqi, Mohammad Nejatullah, 2006. "Islamic Banking And Finance In Theory And Practice: A Survey Of State Of The Art," Islamic Economic Studies, The Islamic Research and Training Institute (IRTI), vol. 13, pages 2-48.
  7. Sahlman, William A., 1990. "The structure and governance of venture-capital organizations," Journal of Financial Economics, Elsevier, vol. 27(2), pages 473-521, October.
  8. 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.
  9. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
  10. Douglas Gale & Martin Hellwig, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Oxford University Press, vol. 52(4), pages 647-663.
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