Financing and corporate growth under repeated moral hazard

Ronald W. Anderson and Kjell Nyborg

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: This paper considers the impact of financial contracting on growth by exploring a model where entrepreneurs initially do R&D but subsequently need both outside investors to provide funds for capital investments and outside mangers to operate the firm efficiently some time after assets are in place. The source of contracting inefficiency is that insiders can divert cash flows for their own benefit. We employ a repeated games framework which allows us to model outside equity as well as inside equity and debt. We call our framework the two-stage model of firm growth. A key finding is that outside equity promotes ex post efficiently (second stage growth) at the expense of ex ante efficiently (first stage growth) which debt work the opposite way. This is because equity promotes replacement of the entrepreneur, while debt promotes entrenchment. So debt has the disadvantage that it is less conducive to the implementation of second stage growth than equity, but the advantage that it provides the entrepreneur with more incentives to do R&D in the first place. Furthermore, equity is fragile, in the sense that moral hazard may be so high that investors will not finance the firm, regardless of the discount rate. In contrast, debt financing definitely can be raised for low discount rates. a prediciton of the model is that in a cross-section of firms, we should observe a preponderance of high levered, closely-held firms which have stagnated after an early growth phase.

Keywords: corporate growth; incomplete financial contracting; outside equity; debt; repeated moral hazard (search for similar items in EconPapers)
JEL-codes: G30 L14 O33 (search for similar items in EconPapers)
Pages: 38 pages
Date: 2001-04
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Downloads: (external link)
http://eprints.lse.ac.uk/25050/ Open access version. (application/pdf)

Related works:
Journal Article: Financing and corporate growth under repeated moral hazard (2011)
Working Paper: Financing and Corporate Growth under Repeated Moral Hazard (2001)
Working Paper: Financing and Corporate Growth under Repeated Moral Hazard (2001)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:25050

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