The Financing and Redeployment of Specific Assets
Michel A. Habib
University of Zurich; Ecole Polytechnique Fédérale de Lausanne - Swiss Finance Institute
D. Bruce Johnsen
George Mason University - School of Law; PERC - Property and Environment Research Center
Journal of Finance, Vol. 20, No. 20, 1998
We model the role various forms of nonrecourse secured debt play in efficiently allocating control rights over assets whose value is state-specific. Ex ante, the entrepreneur makes a noncontractable investment that is specific to the best use of the asset in the status quo, or good, states. The lender makes a noncontractable investment in redeployment that is specific to the next best use of the asset in the bad states. The face amount of the loan is chosen to equal the value of the asset in the critical state that separates the good and bad states, with the loan being secured by the asset. If a good state prevails, the entrepreneur maintains control and captures the entire surplus from his use of the asset. If a bad state prevails, he defaults and relinquishes the asset because it is worth less to him than his obligation under the loan. The lender then redeploys the asset to its next best alternative use and captures the entire surplus from doing so. This state-contingent transfer of control avoids the ex post bargaining that wold otherwise split the redeployment surplus between the parties and distort their ex ante specific investments. Unlike other prominent models of financial contracting, ours imposes no wealth constraint on the entrepreneur and requires no intermediate signal to identify the ex post state of the world. Moreover, it is consistent with a wide range of financial practices including financial leasing, real options, vendor financing, secured and unsecured debt, project finance, and the general pattern of debt priorities and their disposition in bankruptcy.
JEL Classification: G31, G32
Date posted: November 11, 1998
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