Financing Capacity with Stealing and Shirking

Francis de Véricourt () and Denis Gromb
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Francis de Véricourt: European School of Management and Technology, 10178 Berlin, Germany

Management Science, 2019, vol. 65, issue 11, 5128-5141

Abstract: We study a firm’s capacity choice under demand uncertainty given that it must finance this investment externally. Sharing profits with investors causes governance problems affecting both capacity and demand: the firm may “steal” capital, which reduces effective capacity, and “shirk” on market development, which reduces demand. We adopt an optimal contracting approach whereby the firm optimizes among feasible financial claims derived endogenously. We characterize its optimal financing and capacity choices. First, debt financing is optimal: it minimizes the incentives to both divert and shirk. Second, the firm underinvests (overinvests) if the effort problem is mild (severe) enough relative to the diversion problem. Thus, a worsening of the same governance problem can lead to over- or underinvestment depending on circumstances. Third, we find that the diversion and shirking problems interact in their impact on capacity investment. In particular, if the shirking problem is mild enough, the more severe the diversion problem, the less the firm invests. However, if the shirking problem is severe enough, the effect of diversion is reversed: the more severe the diversion problem, the more the firm invests.

Keywords: capacity investment; optimal contracts; capital diversion; financial constraints; newsvendor model; moral hazard (search for similar items in EconPapers)
Date: 2019
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Citations: View citations in EconPapers (9)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:65:y:2019:i:11:p:5128-5141

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