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Moral hazard and capital structure dynamics

  • Mathias Dewatripont
  • Patrick Legros
  • Steven Matthews

We base a contracting theory for a startup 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 nondebt simple contract achieves efficiency-the noncontractibility of effort does not lower welfare. Thus, when the noncontractibility of effort matters, our results mirror typical capital structure dynamics: an early use of debt claims, followed by a switch to equity-like claims. © 2003 by the European Economic Association.

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Paper provided by ULB -- Universite Libre de Bruxelles in its series ULB Institutional Repository with number 2013/9629.

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Date of creation: 2003
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Publication status: Published in: Journal of the European Economic Association (2003) v.1,p.890-930
Handle: RePEc:ulb:ulbeco:2013/9629
Note: SCOPUS: ar.j
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