Strategic default increases the expected recovery rate from bankruptcy, which is a costly event. When investors cannot commit upfront to bankrupt defaulting borrowers, recovery rates are essential in sustaining investment, and optimal financ- ing contracts may generate incentives for borrowers to strategically default on their debts ex post. Where bankruptcy costs are high (at the extensive margin), strategic default is necessary for the marginal firm to be able to invest. Where costs are low (at the intensive margin), high profitability firms optimally choose financing terms that induce strategic default, even if this is anticipated by all parties and other feasible terms could prevent it. These firms are characterized by high probabil- ity of default and low expected losses given default. It follows that distinguishing between credit events is critical for estimating expected default costs.
I consider a costly-state-verification model where investors observe the realized return with some probability. I interpret a higher probability that the investors are informed as capturing either the transparency of a firm’s business, or the informational efficiency of the market it operates in. The model covers all degrees of informational asymmetries between two extremes: full opacity (Gale and Hellwig (1985)) and perfect information (Modigliani and Miller(1958)). For intermediate degrees of asymmetric information, I find that the optimal capital structure can be implemented by a mixture of debt and equity and, consistently with the evidence, leverage negatively correlates with transparency.
We consider a model of external financing in which entrepreneurs are privately informed about the quality of their projects and seek funds from competitive financiers. The literature restricts attention to monotonic or ‘manipulation proof’ securities and finds that straight debt is the unique optimal contract. We characterize the optimal contract when entrepreneurs can misreport their earnings by some amount. Straight debt is often suboptimal and never uniquely optimal. The optimal contract is non-monotonic and involves profit manipulation in equilibrium. It can be implemented as debt with performance bonuses.