Abstract
When firms want to raise external financing, why do they resort to contracts with fixed repayment, i.e., standard debt contracts? The canonical work of Gale and Hellwig (Rev Econ Stud, 52(4):647–663, 1985) gives the following answer to this question: Assuming that only the entrepreneur can observe the project’s outcome free of charge, the standard debt contract proves to be an incentive-compatible financing design. However, this approach remains inadequate, as neither the lender nor the borrower is given the possibility to act strategically. The paper at hand takes up this aspect. By means of a simple game-theoretic model and focusing on a binary outcome setting, it is shown that every risky standard debt contract is dominated by at least one ownership contract. In this respect, costly state verification cannot act as a raison d’être of contracts with fixed repayment.
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Notes
Occasionally, this is called a situation of “semiverifiable” results, cf. Tirole (2006), pp. 131 and 138.
Our understanding of strategic behavior coincides with the work of Dixit and Nalebuff (1991).
In reality, inspection costs may depend on the true cash flow. Yet, in the context of our model, this would not provide further insights.
Non-pecuniary penalties such as imprisonment or loss of reputation exhibit monetary equivalents to the entrepreneur, but no utility to the investor (cf. Diamond 1984, p. 396). In cases where the penalty z (partially) benefits the investor, our results continue to hold in a slightly weakened manner.
Cf. Myerson (1982).
The level of penalty exerts no influence on the agency costs. Although the fine reduces the entrepreneur’s surplus in the event that his/her misreporting has been detected, it coincides with a diminished audit probability of the investor. Comparable results have been deduced in political sciences, where the suitability of penalties for the purpose of crime prevention has been investigated, cf. Tsebelis (1990).
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Acknowledgements
We are deeply indebted to an anonymous referee for thoughtful and constructive comments. For valuable discussions, we are grateful to Harald Kinateder and Michael Krapp.
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Schosser, J., Wilhelm, J. Costly state verification and truthtelling: a note on the theory of debt contracts. Econ Theory Bull 6, 129–139 (2018). https://doi.org/10.1007/s40505-018-0137-8
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DOI: https://doi.org/10.1007/s40505-018-0137-8
Keywords
- Costly state verification
- Financing contracts
- Incentive compatibility
- Perfect Bayesian Nash equilibrium