Long-Term Contracts, Short-Term Investment and Monitoring

Abstract

term contracts, asymmetric information between investors and firms can make it impossible to implement profitable long-term projects. The paper characterizes the structure of optimal, renegotiation-proof contracts for unmonitored and monitored finance. Monitoring by investors, although itself subject to distorting incentive constraints, is shown to be able to overcome the short-term bias of investment and thus to lengthen the firms' planning horizon. I. INTRODUCTION An important question in the literature on corporate finance in the recent years has been whether the dependence on outside finance can force firms to undertake inefficient amounts of investment. Little work has been done, however, on the impact of outside finance on the quality of investment. The present paper studies this issue in the context of a question which has attracted considerable attention in the financial press and in the economic policy debate: can the dependence on outside finance lead a firm to undertake inefficient myopic investments?' To do this, the paper studies a dynamic model of financial contracting that allows one to characterize the choice of a firm's investment horizon. It points to information asymmetries as responsible for investment myopia, discusses the costs and benefits of monitoring as a reaction to it, and characterizes the optimal dynamic debt structure for unmonitored, as well as for monitored finance. According to standard financial theory, the market sees through the corporate veil and encourages the choice of efficient projects. In response to this, an important recent literature has developed more explicit theories of financial contracts and their role for the behaviour of imperfectly informed and strategically acting economic agents.2 This paper builds on this literature and analyses the problem of optimal financial contracting for a firm that wants to raise capital for a risky long-term investment project. The framework used to study the issue is a simple two-period contracting model, complicated by the interplay of hidden-characteristics and hidden-action problems on the side of the firm. More specifically, the probability distribution of project returns is assumed to depend on the intrinsic quality of the project, as well as on the investment horizon and effort chosen