Costly state verification and optimal investment

Bappaditya Mukhopadhyay ()
Authors registered in the RePEc Author Service: Bappaditya Mukhopadhyay () and Bappaditya Mukhopadhyay

Journal of Economics and Finance, 2002, vol. 26, issue 3, 233-248

Abstract: We model a lender-borrower relationship in a CSV framework. The project available with the firm is characterized by first-order stochastic dominance. The lender audits the borrower to prevent the latter from strategic default. In this setup, we find the optimal contract is the standard debt contract. However, a debt contract leads to overinvestment. This result is in sharp contrast to those obtained in the literature. The default probability of the project can be influenced by the nature of financial contract in place. The model also derives the relationship between the optimal debt equity ratio and the auditing costs. Copyright Springer 2002

Date: 2002
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Persistent link: https://EconPapers.repec.org/RePEc:spr:jecfin:v:26:y:2002:i:3:p:233-248

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DOI: 10.1007/BF02759709

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