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Moral Hazard and Capital Structure Dynamics
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Moral Hazard and Capital Structure Dynamics

Author

Listed:
  • Mathias Dewatripont

    (Free University of Brussels (VUB/ULB) - European Center for Advanced Research in Economics and Statistics (ECARES))

  • Patrick Legros

    (Free University of Brussels (VUB/ULB) - European Center for Advanced Research in Economics and Statistics (ECARES))

  • Steven A. Matthews

    (Department of Economics, University of Pennsylvania)

Abstract

We base a contracting theory for a start-up firm on an agency model with observable but nonverifiable effort, and renegotiable contracts. Two essential restrictions on simple contracts are imposed: the entrepreneur must be given limited liability, and the investor’s earnings must not decrease in the realized profit of the firm. All message game contracts with pure strategy equilibria (and no third parties) are considered. Within this class of contracts/equilibria, and regardless of who has the renegotiating bargaining power, debt and convertible debt maximize the entrepreneur’s incentives to exert effort. These contracts are optimal if the entrepreneur has the bargaining power in renegotiation. If the investor has the bargaining power, the same is true unless debt induces excessive effort. In the latter case, a non-debt simple contract achieves efficiency — the non-contractibility of effort does not lower welfare. Thus, when the non-contractibility of effort matters, our results mirror typical capital structure dynamics: an early use of debt claims, followed by a switch to equity-like claims.

Suggested Citation

  • Mathias Dewatripont & Patrick Legros & Steven A. Matthews, 2003. "Moral Hazard and Capital Structure Dynamics," PIER Working Paper Archive 03-006, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
    • Handle: RePEc:pen:papers:03-006
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    More about this item

    Keywords

    Moral hazard; renegotiation; convertible debt; capital structure;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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