Disputes, debt and equity

Alfred Duncan and Charles Nolan

Theoretical Economics, 2019, vol. 14, issue 3

Abstract: We show how the prospect of disputes over firms' revenue reports promotes debt financing over equity. This is demonstrated in a costly state verification model with a risk averse entrepreneur. The prospect of disputes encourages incentive contracts that limit penalties and avoid stochastic monitoring, even when the lender can commit to stochastic monitoring. Consequently, optimal contracts shift from equity toward standard debt. In short: When audit signals are weakly correlated with true incomes, standard debt contracts emerge as optimal; if audit signals are highly correlated with true incomes, optimal contracts resemble equity. When audit costs are sufficiently high, stochastic monitoring may be optimal. Optimal standard debt contracts under imperfect audits are shown to reproduce key empirical facts of US firm borrowing.

Keywords: Microeconomics; costly state verification; external finance; leverage (search for similar items in EconPapers)
JEL-codes: D52 D53 D82 D86 (search for similar items in EconPapers)
Date: 2019-08-02
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://econtheory.org/ojs/index.php/te/article/viewFile/20190887/24486/711 (application/pdf)

Related works:
Working Paper: DISPUTES, DEBT AND EQUITY (2017)
Working Paper: Disputes, Debt and Equity (2014)
Working Paper: Disputes, Debt and Equity (2014)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:the:publsh:2574

Access Statistics for this article

Theoretical Economics is currently edited by Simon Board, Todd D. Sarver, Juuso Toikka, Rakesh Vohra, Pierre-Olivier Weill

More articles in Theoretical Economics from Econometric Society
Bibliographic data for series maintained by Martin J. Osborne ().