Optimal Long-Term Financial Contracting with Privately Observed Cash Flows

Abstract:     
We characterize the optimal long-term financial contract in a setting in which a risk-neutral agent with limited capital seeks financing for a project that pays stochastic cash flows over many periods. These cash flows are observable to the agent but not to investors. The agent can be induced to pay investors via the threat of the loss of control of the project. After solving for the contract as an optimal mechanism, we demonstrate that it can be implemented by a combination of equity, long-term debt and a line of credit - very simple, standard securities. Thus our model provides a theory of capital structure, capturing both optimal debt maturity and debt vs. equity financing. Equity is issued to investors and is also used for the agent's compensation. In equilibrium, the agent may default on the debt and control of the project may pass to debt holders. The optimal capital structure is robust in the sense that it is independent of the amount financed and under certain circumstances, independent of the severity of the moral hazard problem. We also show how our characterization applies to settings in which the agent undertakes hidden effort, or can alter the risk of cash flows.

Keywords: Optimal contracting, security design, capital structure, debt maturity, agency, moral hazard, principal agent, dynamic programming, incentives, cash flow diversion, asset substitution, default, credit line, compensating balance, debt, equity, dividend policy

JEL Classifications: D82, G32, E24, J41, G21

Working Paper Series