Disputes, Debt and Equity

51 Pages Posted: 14 Nov 2017

See all articles by Alfred Duncan

Alfred Duncan

University of Kent - School of Economics

Charles Nolan

University of St. Andrews

Date Written: July 1, 2017

Abstract

We show how the prospect of disputes over firms’ revenue reports promotes debt financing over equity. These findings are presented within a costly state verification model with a risk averse entrepreneur. The prospect of disputes encourages incentive contracts that limit penalties and avoid stochastic monitoring, even when the lender can commit to stochastic monitoring strategies. Consequently, optimal contracts shift away from equity and toward standard debt. For a useful special case of the model, closed form solutions are presented for leverage and consumption allocations under efficient debt contracts. Some empirical implications of the theory are pursued.

Keywords: Microeconomics, Costly State Verification, External Finance, Leverage

JEL Classification: D52, D53, D82, D86

Suggested Citation

Duncan, Alfred and Nolan, Charles, Disputes, Debt and Equity (July 1, 2017). Available at SSRN: https://ssrn.com/abstract=3069639 or http://dx.doi.org/10.2139/ssrn.3069639

Alfred Duncan (Contact Author)

University of Kent - School of Economics ( email )

CT2 7NP
United Kingdom

HOME PAGE: http://https://www.kent.ac.uk/economics/staff/profiles/alfred-duncan.html

Charles Nolan

University of St. Andrews ( email )

North St
Saint Andrews, Fife KY16 9AJ
United Kingdom

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