Disputes, debt and equity

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
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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