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Optimal Multiple Loan Contracting under Sequential Audits and Contagion Losses

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Abstract

We propose a rationale for the joint financing of two independent projects based on the reduction in audit costs resulting from endogenous sequential verification. This cost reduction occurs not only when joint financing offers coinsurance benefits, but, remarkably, also in the presence of contagion losses -where the failure of one project negatively impacts the other. This is because the benefits from endogenous verification - namely, the cost saving from audits optimally decreasing in the reported outcome - may offset the additional cost arising from contagion, specifically, the potential need to audit a successful project due to the failure of the other. We provide a detailed characterisation of the optimal contract, showing that under certain conditions it may take the form of standard debt. Furthermore, we conduct a comparative static analysis relating the optimality of joint financing to the quality of accounting information. Importantly, we find that with fully transparent accounting information, joint financing always dominates single financing even under contagion. The results remain robust across scenarios involving simultaneous audits and multiple projects.

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  • Anna Maria C. Menichini & Peter Simmons, 2024. "Optimal Multiple Loan Contracting under Sequential Audits and Contagion Losses," CSEF Working Papers 742, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
    • Handle: RePEc:sef:csefwp:742
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    Keywords

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    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

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