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Financing and corporate growth under repeated moral hazard

Anderson, Ronald W. and Nyborg, Kjell G. (2001) Financing and corporate growth under repeated moral hazard. Discussion paper, 376. Financial Markets Group, London School of Economics and Political Science, London, UK.

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Abstract

This paper considers the impact of financial contracting on growth by exploring a model where entrepreneurs initially do R&D but subsequently need both outside investors to provide funds for capital investments and outside mangers to operate the firm efficiently some time after assets are in place. The source of contracting inefficiency is that insiders can divert cash flows for their own benefit. We employ a repeated games framework which allows us to model outside equity as well as inside equity and debt. We call our framework the two-stage model of firm growth. A key finding is that outside equity promotes ex post efficiently (second stage growth) at the expense of ex ante efficiently (first stage growth) which debt work the opposite way. This is because equity promotes replacement of the entrepreneur, while debt promotes entrenchment. So debt has the disadvantage that it is less conducive to the implementation of second stage growth than equity, but the advantage that it provides the entrepreneur with more incentives to do R&D in the first place. Furthermore, equity is fragile, in the sense that moral hazard may be so high that investors will not finance the firm, regardless of the discount rate. In contrast, debt financing definitely can be raised for low discount rates. a prediciton of the model is that in a cross-section of firms, we should observe a preponderance of high levered, closely-held firms which have stagnated after an early growth phase.

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2001 The Authors
Library of Congress subject classification: H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: G - Financial Economics > G3 - Corporate Finance and Governance > G30 - General
O - Economic Development, Technological Change, and Growth > O3 - Technological Change; Research and Development > O33 - Technological Change: Choices and Consequences; Diffusion Processes
L - Industrial Organization > L1 - Market Structure, Firm Strategy, and Market Performance > L14 - Transactional Relationships; Contracts and Reputation; Networks
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 376
Date Deposited: 28 Aug 2009 11:43
URL: http://eprints.lse.ac.uk/25050/

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