Optimal Debt with Unobservable Investments

Posted: 23 Jan 2004

See all articles by Paul Povel

Paul Povel

University of Houston - Department of Finance, C.T. Bauer College of Business

Michael Raith

University of Rochester - Simon Business School

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Abstract

We study financial contracting when both an entrepreneur's investment and the resulting revenue are unobservable to an outside investor. We show that a debt contract is always optimal; repayment is induced by a liquidation threat that increases with the extent of default. Moreover, when the entrepreneur's decision concerns the scale of his project, a contract that minimizes liquidation losses is optimal. When the decision concerns managerial effort or project risk, however, it may be optimal to write a contract with a greater threat of liquidation, to induce the entrepreneur to exert more effort or to choose a less risky project.

Keywords: Financial contracting, security design, debt, bankruptcy, agency problems, moral hazard, risk-shifting, asset substitution

JEL Classification: D82, G32, G33

Suggested Citation

Povel, Paul and Raith, Michael, Optimal Debt with Unobservable Investments. Available at SSRN: https://ssrn.com/abstract=488844

Paul Povel

University of Houston - Department of Finance, C.T. Bauer College of Business ( email )

University of Houston
334 Melcher Hall
Houston, TX 77204
United States
713-743-4759 (Phone)

HOME PAGE: http://www.bauer.uh.edu/povel

Michael Raith (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States
585-275-8380 (Phone)
585-273-1140 (Fax)

HOME PAGE: http://works.bepress.com/michael_raith/

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