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Financial Contracting and the Specialization of Assets

44 Pages Posted: 7 Apr 2008 Last revised: 3 Feb 2009

Robert Marquez

University of California, Davis

M. Deniz Yavuz

Purdue University - Krannert School of Management

Date Written: January 28, 2009

Abstract

We analyze the nature of financial contracting when an entrepreneur can choose the specificity of investments and financial contracts are incomplete. Investing in project specific assets increases productivity but decreases liquidation value. This creates a strategic incentive to specialize assets to decrease the bargaining power of the financier when debt financing is used. When the financier can contribute to the project, equity financing may be feasible if the entrepreneur is willing to take the firm public in order to make cash flows contractible and benefit from the financier's input. The entrepreneur faces a tension between going public, which is costly but induces the financier to exert effort, and remaining private, which limits the opportunities for contracting but allows the entrepreneur to divert cash flows. We predict that firms with greater opportunity to specialize will be mostly financed by equity, which results in optimal investment and exit decisions.

Keywords: venture capital, bank, incomplete contracts, financial contracts, asset specialization, redeployability, liquidation

JEL Classification: G21, G24, G32

Suggested Citation

Marquez, Robert and Yavuz, M. Deniz, Financial Contracting and the Specialization of Assets (January 28, 2009). Available at SSRN: https://ssrn.com/abstract=1116420 or http://dx.doi.org/10.2139/ssrn.1116420

Robert S. Marquez

University of California, Davis ( email )

One Shields Avenue
Davis, CA 95616
United States

M. Deniz Yavuz (Contact Author)

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

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