Financing and Corporate Growth Under Repeated Moral Hazard

IFA Working Paper No. 304

37 Pages Posted: 3 Aug 2000

See all articles by Kjell G. Nyborg

Kjell G. Nyborg

University of Zurich - Department of Banking and Finance; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Ronald W. Anderson

London School of Economics & Political Science - Department of Finance; Centre for Economic Policy Research (CEPR); Sun Yat-sen University (SYSU) - Xinhua College

Multiple version iconThere are 2 versions of this paper

Date Written: April 2001

Abstract

This paper considers the impact of financial contracting on growth by exploring a model where entrepreneurs initially do R&D but subsequently need both outside investors to provide funds for capital investments and outside managers to operate the firm efficiently some time after assets are in place. The source of contracting inefficiency is that insiders can divert cash flows for their own benefit. We employ a repeated game framework, which allows us to model outside equity as well as inside equity and debt. We call our framework the two-stage model of firm growth. A key finding is that outside equity promotes ex post efficiency (second stage growth) at the expense of ex ante efficiency (first stage growth), while debt works the opposite way. This is because equity promotes replacement of the entrepreneur, while debt promotes entrenchment. So debt has the disadvantage that it is less conducive to the implementation of second stage growth than equity, but the advantage that it provides the entrepreneur with more incentives to do R&D in the first place. Furthermore, equity is fragile, in the sense that moral hazard may be so high that investors will not finance the firm, regardless of the discount rate. In contrast, debt financing definitely can be raised for low discount rates. A prediction of the model is that in a cross-section of firms, we should observe a preponderance of highly levered, closely held firms, which have stagnated after an early growth phase.

Note: Previously titled "R & D, Capital Investments, and Financing under Repeated Moral Hazard"

Keywords: Corporate growth, incomplete financial contracting, outside equity, debt, repeated moral hazard

JEL Classification: G30, O33, L14

Suggested Citation

Nyborg, Kjell G. and Anderson, Ronald W., Financing and Corporate Growth Under Repeated Moral Hazard (April 2001). IFA Working Paper No. 304, Available at SSRN: https://ssrn.com/abstract=232535 or http://dx.doi.org/10.2139/ssrn.232535

Kjell G. Nyborg

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland
+41 (0)44 634 2980 (Phone)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Ronald W. Anderson (Contact Author)

London School of Economics & Political Science - Department of Finance ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44 20 7955 6204 (Phone)
+44 20 7955 7420 (Fax)

HOME PAGE: http://personal.lse.ac.uk/ANDERSOR/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Sun Yat-sen University (SYSU) - Xinhua College ( email )

China

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