Duncan, A. and Nolan, C. (2019) Disputes, debt and equity. Theoretical Economics, 14(3), pp. 887-925. (doi: 10.3982/TE2574)
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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.
Item Type: | Articles |
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Status: | Published |
Refereed: | Yes |
Glasgow Author(s) Enlighten ID: | Nolan, Professor Charles |
Authors: | Duncan, A., and Nolan, C. |
College/School: | College of Social Sciences > Adam Smith Business School > Economics |
Journal Name: | Theoretical Economics |
Publisher: | Wiley |
ISSN: | 1933-6837 |
ISSN (Online): | 1555-7561 |
Published Online: | 05 August 2019 |
Copyright Holders: | Copyright © 2019 The Authors |
First Published: | First published in Theoretical Economics 14:887-925 |
Publisher Policy: | Reproduced under a Creative Commons License |
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