Firms, Contracts, and Financial Structure

Firms, Contracts, and Financial Structure

Firms, Contracts, and Financial Structure

Firms, Contracts, and Financial Structure

Synopsis

This work uses recent developments in the theory of incomplete contracts to analyze a range of topics in organization theory and corporate finance. Beginning with a general model of the firm, Hart analyzes in greater depth the financial structure of firms, debt collecting and bankruptcy. Oliver Hart is a leading researcher in this area, and these Clarendon Lectures are an important contribution to contact theory. The work will be of interest to teachers, graduate students and advanced students of microeconomics, the theory of the firm, industrial organization, and finance.

Excerpt

Previous chapters have shown that an agent should own an asset if he has important asset-specific investment decisions to make or if he has human capital essential for the asset's use. This chapter considers what happens if the agent is wealth- constrained and cannot buy the asset outright. Under these conditions, the agent will have to raise funds from an outside investor (or from a set of investors) to purchase the asset. This creates a new agency problem. the agent may behave opportunistically, thus depriving the investor of an adequate return on her investment.

The chapter studies how the investor can protect herself against such opportunistic behaviour. (I now depart from the buyer-seller relationship and focus on a single agent and a single investor.) One possibility is for the investor to take a controlling interest in the asset. However, the investor may then abuse her power; for example, she may sell the asset without taking into account the agent's benefit from operating it. It will be shown that in some cases it is better for the investor to enter into a financial contract with the agent of the following form. the agent borrows money from the investor and promises to make certain repayments. If he makes them, he retains control of the asset. If he does not make them, control shifts to the investor. in other words, the theory of incomplete contracts and property rights--when extended to the case of limited wealth--can explain the use of debt financing.

The chapter begins with a description of the leading incomplete contracting theory of debt, which is due to Aghion andBolton (1992). I argue that the Aghion-Bolton model explains transfers in control but does not explain the use of a standard debt contract. Section 2 discusses a model, based on Hart andMoore (1989), which comes closer to justifying a standard debt contract. (For a related analysis, see Bolton andScharfstein (1990).) the model in Section 2 extends for two periods and supposes perfect certainty. It turns out to be easy to generalize the analysis to many periods . . .

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