Ebook Expropriation Risk, Governance Control and Equilibrium Financial Contract
Different firms rely on different types of financial instruments to conduct their business, which differ in terms of how they are repaid to the investors, how secure the repayment is, who retains the control rights in the event of failure to repay, etc. The Modigliani Miller theorem (1958) notwithstanding, some firms choose to finance their investment project by issuing debts to the financial market, whereas others have to give investors equity stakes and some control rights. This paper attempts to address this observation by studying a situation where nonverifiability of cash flow and contractual incompleteness result in different optimal financial arrangements depending on the characteristics of an investment project to be undertaken.
Suppose that an investment project lasts for two periods, yielding a strictly positive expected net cash flow in each period, but that the cash flows accrue to entrepreneur and are not verifiable. Since a potential investor for the project is at the risk of expropriation by the entrepreneur, the investor will be reluctant to provide financing unless an appropriate financial arrangement is made. There can be two mechanisms to deal with this expropriation risk: one is the threat of liquidation after first-period default, and the other is the governance control which converts a part of cash flow into verifiable income and thus reduces the need for liquidation threat. These mechanisms, however, are not costless. A better governance mechanism costs more to design and maintain, and an actual liquidation results in the loss of positive surplus of the second period. Therefore, the optimal financial arrangement will maximize the (expected) net surplus while ensuring that the investor be repaid.
In solving the problem, we follow the incomplete contracting/property right approach to the financial structure. The key insight from this approach is that contractual incompleteness requires the distribution of control rights to different contracting parties, and appropriate income streams have to be attached to each of the control rights to provide the controlling party with proper incentives. In the context of our model, the liquidation decision is contractible since it can be contingent upon repayment from entrepreneur, whereas the governance decision, or at least some elements of it, will not be contractible. Thus, unlike other models in the literature, e.g., Aghion and Bolton (1992) and Dewatripont and Tirole (1994), which concern ex post control rights, we will analyze the ex ante bargaining between entrepreneur and investor in which “governance right” to the governance control decision and “contracting right” to the verifiable income stream are assigned to the parties. We call the outcome of this bargaining process a financial arrangement denoted by EI for example, which is the entrepreneur governance/investor-contract arrangement. Subsequently to the bargaining, the “governance” party chooses a level of governance control and then the “contracting” party offers a financing contract. In efficient bargaining with side payment, an equilibrium financial arrangement will maximize the expected net surplus. Then the financial structure of firm is determined according to the financing contract of the equilibrium financial arrangement.
We show that different equilibrium financial arrangements obtain, depending upon the profitability of the investment project, the governance control cost, and the existence of opportunism. In the absence of opportunism risk, the entrepreneur’s governance control and contract EE is essentially the equilibrium financial arrangement and Pareto-efficient subject to the incentive compatibility constraint. A highly profitable investment project is financed with a positive probability of liquidation after default, while a moderately profitable project is always refinanced but requires sufficiently effective governance control.
On the other hand, when risk of opportunism is present, further protection against expropriation is necessary for the investor. This can be achieved by giving her the governance right for a highly profitable project, in which case IE is the equilibrium with a positive probability of liquidation, or by giving her the contracting right as well for a moderately profitable project, in which case II is the equilibrium with no liquidation. Regardless of opportunism risk, the equilibrium financial arrangement depends on the trade-off between the costs of liquidation threat and governance control: for a highly (moderately) profitable project, the former (the latter) is a less costly mechanism for investor protection.
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