Moral Hazard and Capital Structure Dynamics

58 Pages Posted: 23 Jul 2002

See all articles by Mathias Dewatripont

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); Northeastern University, department of economics; Centre for Economic Policy Research (CEPR)

Steven A. Matthews

University of Pennsylvania - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: July 5, 2002

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.

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

JEL Classification: D820, L140, O261

Suggested Citation

Dewatripont, Mathias and Legros, Patrick and Matthews, Steven A., Moral Hazard and Capital Structure Dynamics (July 5, 2002). Available at SSRN: https://ssrn.com/abstract=318924 or http://dx.doi.org/10.2139/ssrn.318924

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)

London
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)

Northeastern University, department of economics ( email )

301 Lake Hall
Boston, MA 02115
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Steven A. Matthews (Contact Author)

University of Pennsylvania - Department of Economics ( email )

Ronald O. Perelman Center for Political Science
133 South 36th Street
Philadelphia, PA 19104-6297
United States
215-898-7749 (Phone)
215-573-2057 (Fax)

HOME PAGE: http://www.econ.upenn.edu/~stevenma

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