Optimal Debt with Unobservable Investments
Posted: 23 Jan 2004
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: Suggested Citation