Project Risk Choices Under Privately Guaranteed Debt Financing

49 Pages Posted: 30 Nov 2004 Last revised: 15 May 2015

See all articles by Issouf Soumaré

Issouf Soumaré

Laval University

Van Son Lai

Université Laval

Paul Angoua

National Bank of Canada

Date Written: November 1, 2004

Abstract

Although a considerable amount of research has been undertaken on detrimental risk taking by managers, much less studies are devoted to endogenizing risk choices in the context of corporate project financing and in the presence of financial guarantees. A firm's risk appetite increases greatly when it has a guarantee contract on its debt, which creates a conflict of interest between the firm and the guarantee provider. To address this moral hazard issue, we propose an equilibrium model in which the borrowing firm and the guarantee provider pre-commit themselves to conscripted risk levels at the signature of the contract. We show if the borrowing firm and the guarantor pre-commit, the equilibrium risk level is lower than the one the firm will choose unilaterally. When the firm's shareholders have a big equity stake in the new project, for short (long) maturity debts, both parties gain by agreeing on a high (low) risk project. We also find that the optimal risk level of the borrowing firm is entirely driven by its ex-post capital structure.

Keywords: Equilibrium, Endogenous risk choices, Financial guarantee, Insurance, Moral hazard, Risk sharing

JEL Classification: G13, G22, G32, G33

Suggested Citation

Soumaré, Issouf and Lai, Van Son and Angoua, Paul, Project Risk Choices Under Privately Guaranteed Debt Financing (November 1, 2004). Quarterly Review of Economics and Finance, Vol. 48, No. 1, 2008. Available at SSRN: https://ssrn.com/abstract=624191 or http://dx.doi.org/10.2139/ssrn.624191

Issouf Soumaré (Contact Author)

Laval University ( email )

Faculty of Business Administration
Department of Finance, Insurance and Real Estate
Quebec, Quebec G1V 0A6
Canada
1418 656 3423 (Phone)
1418 656 2624 (Fax)

Van Son Lai

Université Laval ( email )

FSA ULaval
Quebec G1V 0A6
Canada
418-656-2131, x3943 (Phone)

Paul Angoua

National Bank of Canada ( email )

Quebec, Quebec G2E 6H5
Canada

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