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Limited Liability and Option Contracts in Models with Sequential Investments

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  • Lülfesmann, Christoph

Abstract

The paper investigates a model where two parties sequentially invest in a joint project (an asset). Investments and the project value are unverifiable, and A is wealth constrained so that an initial outlay must be financed by either agent B or an external investor C, say a bank. We show that an option contract in combination with a loan arrangement facilitates first best investments and any distribution of surplus if renegotiation is infeasible. Moreover, the optimal strike price of the option is shown to differ across financing modes. If renegotiation is admitted, the first best can still be attained unless A's bargaining position is too strong. Otherwise, B financing or C financing may become strictly preferable, and a combination of multiple lenders may be optimal.

Suggested Citation

  • Lülfesmann, Christoph, 2001. "Limited Liability and Option Contracts in Models with Sequential Investments," Bonn Econ Discussion Papers 27/2001, University of Bonn, Bonn Graduate School of Economics (BGSE).
    • Handle: RePEc:zbw:bonedp:272001
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    File URL: https://www.econstor.eu/bitstream/10419/78386/1/bgse27_2001.pdf
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    References listed on IDEAS

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    1. Anindya Banerjee & Alan Beggs, 1989. "Efficiency in Hierarchies: Implementing the First-Best Solution by Sequential Actions," RAND Journal of Economics, The RAND Corporation, vol. 20(4), pages 637-645, Winter.
    2. Edlin, Aaron S & Hermalin, Benjamin E, 2000. "Contract Renegotiation and Options in Agency Problems," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 16(2), pages 395-423, October.
    3. Hart, Oliver, 1995. "Firms, Contracts, and Financial Structure," OUP Catalogue, Oxford University Press, number 9780198288817.
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    6. Sahlman, William A., 1990. "The structure and governance of venture-capital organizations," Journal of Financial Economics, Elsevier, vol. 27(2), pages 473-521, October.
    7. Erik Berglöf & Ernst-Ludwig von Thadden, 1994. "Short-Term versus Long-Term Interests: Capital Structure with Multiple Investors," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(4), pages 1055-1084.
    8. Arora, Ashish & Gambardella, Alfonso, 1990. "Complementarity and External Linkages: The Strategies of the Large Firms in Biotechnology," Journal of Industrial Economics, Wiley Blackwell, vol. 38(4), pages 361-379, June.
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    Cited by:

    1. Andreas Roider, 2006. "Delegation of Authority as an Optimal (In)Complete Contract," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 162(3), pages 391-411, September.

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    More about this item

    Keywords

    Option Contracts; Corporate Finance; Sequential Investments; Double Moral Hazard;
    All these keywords.

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • H57 - Public Economics - - National Government Expenditures and Related Policies - - - Procurement
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation

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