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Disputes, Debt and Equity

Duncan, Alfred, Nolan, Charles (2019) Disputes, Debt and Equity. Theoretical Economics, 14 (3). pp. 887-925. ISSN 1933-6837. E-ISSN 1555-7561. (doi:10.3982/TE2574) (KAR id:64213)

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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: Article
DOI/Identification number: 10.3982/TE2574
Uncontrolled keywords: Microeconomics, costly state verification; external finance; leverage
Subjects: H Social Sciences > HB Economic Theory
Divisions: Divisions > Division of Human and Social Sciences > School of Economics
Depositing User: Alfred Duncan
Date Deposited: 01 Nov 2017 21:54 UTC
Last Modified: 04 Jul 2023 12:32 UTC
Resource URI: (The current URI for this page, for reference purposes)

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