Financial Contracting with Correlated Cash-Flows

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School of Business | Doctoral thesis (monograph) | Defence date: 2014-03-24
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Aalto University publication series DOCTORAL DISSERTATIONS, 15/2014
This theses develops a theoretical approach of modeling principal-agent problems with correlated output. Using this formulation we are able to develop a model that can be used to make predictions about relationship between the credit quality of a firm and efficiency of its operations. We examine the question from two important directions. Our first approach is to develop a simple two-period model that could capture the economic intuition in the framework. This model is important for understanding the qualitative results from the interaction between the agency problem and firm quality. The second approach derives the optimal contract in continuous time with infinite horizon. This model constitutes an important first step for a framework that could later be used to derive structural estimations for security prices from the data. To be more concrete, consider a firm that needs an initial investment to get started. An outside investor (principal) is needed to finance this investment. An entrepreneur or a manager (agent) is hired to handle the daily operations. However, this agent is more familiar with the details of the firm and can use this informational advantage for his private benefits. To prevent the agent from taking advantage of his superior knowledge, the principal has to provide him incentives. The optimal incentive scheme is determined in a contract on which the players agree in the beginning of the relationship. In practice, the principal rewards the agent following a high output by leaving him part of the surplus as a compensation. If the output falls too low, she punishes him by terminating the contract. The correlation implies that the firm value depends on the past performance. This feature has two consequences in the model. Firstly, contracting is efficient if output is high and inefficient if it is low. In the optimal contract, the termination is eventually inefficient. The degree of the inefficiency increases if the principal has a higher share of the claims on the firm assets. Secondly, the agent has asymmetric information, not only about the current value, but also about the future prospects. This feature eventually creates a challenge from the modeling point of view. If the agent deviates, the players' perception about the economic environment diverge. We need to check that the agent cannot profit by gaining more beneficial environment. Suppose, for simplicity, that the principal holds debt while the agent holds equity. Our model predicts that firms with higher debt-equity ratios are operated more inefficiently than firms of which capital structure consists of a higher fraction of equity. Following good past performance, the firm pays of its debt, and is operated more efficiently.
Julkaistu vain painettuna, saatavuus katso Bibid. Published only in printed form, availability see Bibid
Supervising professor
Välimäki, Juuso, Professor, Aalto University, Department of Economics, Finland
principal-agent model, limited liability, financial contracting
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