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http://ssrn.com/abstract=318924
 
 

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Moral Hazard and Capital Structure Dynamics


Mathias Dewatripont


Université Libre de Bruxelles (ULB) - European Center for Advanced Research in Economics and Statistics (ECARES); Centre for Economic Policy Research (CEPR)

Patrick Legros


Université Libre de Bruxelles (ULB) - European Center for Advanced Research in Economics and Statistics (ECARES); Centre for Economic Policy Research (CEPR)

Steven A. Matthews


University of Pennsylvania - Department of Economics

July 5, 2002

PIER Working Paper No. 02-016

Abstract:     
We base a contracting theory for a start-up 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 non-debt simple contract achieves efficiency; the non-contractibility of effort does not lower welfare. Thus, when the non-contractibility of effort matters, our results mirror typical capital structure dynamics: an early use of debt claims, followed by a switch to equity-like claims.

Number of Pages in PDF File: 58

Keywords: Moral Hazard, Renegotiation, Convertible Debt, Capital Structure

JEL Classification: D820, L140, O261

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Date posted: July 23, 2002  

Suggested Citation

Dewatripont, Mathias and Legros, Patrick and Matthews, Steven A., Moral Hazard and Capital Structure Dynamics (July 5, 2002). PIER Working Paper No. 02-016. Available at SSRN: http://ssrn.com/abstract=318924 or http://dx.doi.org/10.2139/ssrn.318924

Contact Information

Mathias Dewatripont
Université Libre de Bruxelles (ULB) - European Center for Advanced Research in Economics and Statistics (ECARES) ( email )
Ave. Franklin D Roosevelt, 50 - C.P. 114
Brussels, B-1050
Belgium
+32 2 650 4217/4 (Phone)
+32 2 650 4475 (Fax)
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
Patrick Legros
Université Libre de Bruxelles (ULB) - European Center for Advanced Research in Economics and Statistics (ECARES) ( email )
Ave. Franklin D Roosevelt, 50 - C.P. 114
Brussels, B-1050
Belgium
+32 2 650 4219/3 (Phone)
+32 2 650 4475 (Fax)
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
Steven A. Matthews (Contact Author)
University of Pennsylvania - Department of Economics ( email )
3718 Locust Walk
Philadelphia, PA 19104
United States
215-898-7749 (Phone)
215-573-2057 (Fax)
HOME PAGE: http://www.econ.upenn.edu/~stevenma
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