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.
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 introduce disclosure of evidence about performance in a dynamic agency model with non-verifiable cash flows. Evidence reduces the use of high powered cash incentives, and the optimal contract features “pay for verifiable bad luck”. The firm dynamics can be implemented by long-term debt, equity, and a credit line with interest rate contingent on both the disclosed evidence and the reported cash flow. Perhaps counterintuitively, more frequent expected disclosure might lower the firm’s initial liquidity, and even reduce the ex ante surplus. As more evidence becomes available, two countervailing forces shape the dynamics: on the one hand, the firm’s liquidity is more persistent after disclosure of bad news. On the other hand, the firm faces higher interest rate charges in low cash flow states, absent disclosure. For low profitability firms, and in high interest rate environments, the two effects induce a non-monotonicity in both firm’s value and economic surplus.
Credit failures - new draft coming soon (joint with Herakles Polemarchakis and Luca Zavalloni) - 2017
Sharing hidden losses (joint with Nika Koreli) - 2017