Disputes, Debt and Equity

Alfred Duncan and Charles Nolan

Studies in Economics from School of Economics, University of Kent

Abstract: We show how the prospect of disputes over firms’ revenue reports promotes debt financing over equity. These findings are presented within 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 strategies. Consequently, optimal contracts shift away from equity and toward standard debt. For a useful special case of the model, closed form solutions are presented for leverage and consumption allocations under efficient debt contracts. Some empirical implications of the theory are pursued.

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: 2017-07
New Economics Papers: this item is included in nep-mic
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Citations: View citations in EconPapers (2)

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Related works:
Journal Article: Disputes, debt and equity (2019)
Working Paper: DISPUTES, DEBT AND EQUITY (2017)
Working Paper: Disputes, Debt and Equity (2014)
Working Paper: Disputes, Debt and Equity (2014)
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