Optimal Debt with Unobservable Investments

Abstract

We study financial contracting when both an entrepreneur's investment and the resulting revenue are unobservable to an outside investor. We show that a debt contract is always optimal; repayment is induced by a liquidation threat that increases with the extent of default. Moreover, when the entrepreneur's decision concerns the scale of his project, a contract that minimizes liquidation losses is optimal. When the decision concerns managerial effort or project risk, however, it may be optimal to write a contract with a greater threat of liquidation, to induce the entrepreneur to exert more effort or to choose a less risky project.

Keywords: Financial contracting, security design, debt, bankruptcy, agency problems, moral hazard, risk-shifting, asset substitution

JEL Classification: D82, G32, G33