Theories of Financial Contracting and Debt

Abstract

Abstract Studies the optimal financial contract written by a wealth‐constrained entrepreneur who raises funds from an outside investor to purchase an asset. The models presented assume that the entrepreneur obtains significant (private) benefits from managing a firm and analyse how control rights should be allocated between the parties when contracts are incomplete. The chapter begins with a discussion of the Aghion–Bolton model, which explains shifts in control but not the use of a standard debt contract. Next, a model by Hart and Moore is analysed, which comes closer to explaining the use of a standard debt contract. In these models, debt forces the entrepreneur to pay out funds to investors rather than to himself. Furthermore, the dynamic version of the model sheds light on the maturity structure of debt repayment and the role of collateral in determining whether a project is financed. The Appendix to the chapter reviews an alternative approach to debt contracting, the costly state verification model.