Chapter

Theories of Financial Contracting and Debt

Oliver Hart

in Firms, Contracts, and Financial Structure

Published in print October 1995 | ISBN: 9780198288817
Published online November 2003 | e-ISBN: 9780191596353 | DOI: http://dx.doi.org/10.1093/0198288816.003.0006

Series: Clarendon Lectures in Economics

 Theories of Financial Contracting and Debt

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Studies the optimal financial contract written by a wealth‐constrained entrepreneur who raises funds from an outside investor to purchase an asset. The models presented assume that the entrepreneur obtains significant (private) benefits from managing a firm and analyse how control rights should be allocated between the parties when contracts are incomplete. The chapter begins with a discussion of the Aghion–Bolton model, which explains shifts in control but not the use of a standard debt contract. Next, a model by Hart and Moore is analysed, which comes closer to explaining the use of a standard debt contract. In these models, debt forces the entrepreneur to pay out funds to investors rather than to himself. Furthermore, the dynamic version of the model sheds light on the maturity structure of debt repayment and the role of collateral in determining whether a project is financed. The Appendix to the chapter reviews an alternative approach to debt contracting, the costly state verification model.

Keywords: Aghion–Bolton model; collateral; control allocation; debt contract; financial contract; incomplete contracts; maturity structure; wealth constraints

Chapter.  13146 words.  Illustrated.

Subjects: Financial Markets

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