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Self-Enforcing Stochastic Monitoring and the Separation of Debt and Equity Claims

51 Pages Posted: 3 Nov 2011  

Harold L. Cole

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 4 versions of this paper

Date Written: October 27, 2011

Abstract

We study the incentive issues associated with self-enforcing stochastic monitoring in a model of investment and production. The efficient contract features a debt-like payment with a threshold in terms of the reported output in which all of the reported output is taken up to the threshold if monitoring doesn't occur and all of the output is taken if monitoring does occur. An output report above the threshold leads to zero probability of monitoring and just the threshold amount being paid out. The efficiency gap between the self-enforcing contract and the commitment constraint is minimized when the monitors holds no part of the residual claim on the firm, which we associate with equity. Misreporting by the manager is an important component of the efficient
contract.

Keywords: Capital Structure, Monitoring, Incentives, Self-Fulfilling

JEL Classification: G32, D82, D86

Suggested Citation

Cole, Harold L., Self-Enforcing Stochastic Monitoring and the Separation of Debt and Equity Claims (October 27, 2011). PIER Working Paper No. 08-025. Available at SSRN: https://ssrn.com/abstract=1159781 or http://dx.doi.org/10.2139/ssrn.1159781

Harold L. Cole (Contact Author)

University of Pennsylvania - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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