Cours Corporate Finance

Introduction
Tirole’s Simple Credit Rationing Model

Equity Multiplier
Theory of Standard Debt Contracts
Corporate Finance 2:
Outside Financing Capacity
Robert Gary-Bobo
Ecole Polytechnique, 2015
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Introduction (1)
We propose here a first elementary study of credit

rationing, debt and equity in simple models of the firm with
moral hazard.
We show that the financial structure of the firm is
determined by the extent of informational asymmetries
between the lenders and the borrowers and by the
incentives provided by the debt structure.
We show why it is important that entrepreneurs who want
to borrow invest their own money in the firm.
This part of the lecture is based on Jean Tirole’s (2006)
Theory of Corporate Finance, Princeton Univ. Press,
Chapter 3.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Introduction(2)
Definition of credit rationing: a borrower is rationed if he
cannot obtain the loan that he wants even though he is
willing to pay the interest that the lenders are asking,
perhaps even a higher interest. Credit rationing is
common-place: fixed lines of credit; loans refused...
Credit rationing is an equilibrium phenomenon driven by
asymmetries of information between borrowers and
lenders.
Adverse Selection problem (Stiglitz and Weiss (1981)). An
increase in the rate of interest may lower the probability of
reimbursement...Imperfectly observable quality of
borrowers...
Moral Hazard (hidden actions; hidden effort...) can also be
a source of credit rationing, as we will see.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Introduction(3)
We first study Tirole’s (2006) simple model of credit. (See

also Holmström and Tirole (1997)). The so-called Fixed
Investment Model with moral hazard.
We then study extensions, the continuous-investment
version of the same model, leading to a theory of the
borrowing capacity of an entrepreneur.
Third, we will study the Costly State Verification Model. We
derive the Standard Debt Contract as an optimal contract.
See Townsend (1979), Gale and Hellwig (1985).
Finally, we expose a simple version of Bolton and
Sharfstein’s (1990) model with nonverifiable income.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Basic Assumptions (1)
An entrepreneur (borrower).
An investment project requiring fixed investment I.
The entrepreneur has cash on hand (or liquid securities)
A < I.
To implement the project the entrepreneur needs (borrows)
I − A.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
If undertaken the project either succeeds: verifiable

income R > 0.
Or the project fails: yields zero income.
Let p denote the probability of success.
The project is subject to moral hazard.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Basic Assumptions(3)
The entrepreneur can exert high effort (work, take no

private benefit), or zero effort (shirk, take a private benefit).
Equivalently, the entrepreneur chooses between project
with high or low probability of success.
High effort yields p = pH ; low effort yields p = pL , with
pL < pH . Denote ∆p = pH − pL .
Low effort yields a private benefit B > 0 to the
entrepreneur. (B can be interpreted as a disutility of effort).
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Borrower and lenders (investors) are risk-neutral.

For simplicity, there is no time preference: investors require
an interest rate equal to 0 (at least).
The entrepreneur is protected by limited liability (income
cannot be negative).
Competition among lenders drive interest and profit to zero.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Basic Assumptions(5)
The loan contract specifies how the profit is shared

between borrower and lenders.
Limited liability implies that both sides receive zero in case
of failure.
Profit sharing: R = Rb + Rl , where Rb is the the borrower’s
share, Rl is the lender’s share.
Lender’s net payoff is Rl − (I − A) in case of success;
−(I − A) in case of failure. The borrower’s payoff is thus
Rb − A in case of success and −A in case of failure.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

The zero-profit constraint for lenders is pH Rl = I − A.
Assuming high effort, the rate of interest is ι, where
1
Rl = (1 + ι)(I − A) or 1+ι= .
pH
The nominal rate of interest ι reflects a default premium.
We assume that the project is viable only if effort is high:
that is,
pH R − I > 0 and pL R − I + B < 0.
No loan giving an incentive to low effort will be granted:

either the lender or the borrower would lose money in
expectation.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
The lender’s credit analysis (1)
The borrower’s tradeoff: obtain private benefit B but reduce

probability of success to pL .
We have the following incentive compatibility constraint, IC:
pH Rb ≥ pL Rb + B or
B
Rb ≥ .
∆p
The highest income that can be pledged to lenders is

R − B/∆p. In expected terms: pH (R − B/∆p).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

The lender’s individual rationality constraint, IR, is therefore

B
pH R − ≥ I − A.
∆p
Financing can be arranged only if

B
A ≥ I − pH R − .
∆p
We assume that I > pH (R − B/∆p).

Otherwise, a lender with A = 0 could obtain credit. The
project’s NPV is smaller than the minimum expected rent
that must be left to the borrower to satisfy IC.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
The borrower must have enough assets

A ≥ A = I − pH (R − B/∆p) in order to be granted credit.
If A < A, the project has positive NPV and yet is not
funded. The parties cannot find an agreement that both
induces high effort and yield enough benefit to lenders.
This is credit rationing. The borrower is ready to give more
of the return to the lender but the lender does not want to
grant such a loan.
If A ≥ A, the entrepreneur can secure financing (we have a
necessary and sufficient condition for financing).
Robert J. Gary-Bobo
Introduction
Equity Multiplier
The entrepreneur offers the minimal claim Rl , such that

pH Rl = I − A.
The entrepreneur’s stake satisfies
I−A I−A B
Rb = R − Rl = R − ≥R− = ,
pH pH ∆p
so that the entrepreneur chooses high effort.

One only lends to the rich.
If A ≥ A, the borrower’s utility is
Ub = pH Rb − A = pH (R − Rl ) − A = pH R − I: the borrower
receives the entire social surplus of the investment.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Determinants of credit rationing
What are the determinants of credit rationing?

A low amount of cash A.
A high agency cost (or agency rent) B/∆p.
Moral hazard is determined by the private benefit B and
the likelihood ratio ∆p/pH .
The likelihood ratio measures how much the observable
result (success or failure) reveals the underlying choice of
effort.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Do investors hold debt or equity?
Remark that the loan contract can be interpreted as debt

here.
This is because we have a two-outcome model.
Interpretation as debt: the borrower must reimburse Rl or
else go bankrupt. In the case of reimbursement, the
borrower keeps the residual R − Rl .
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Interpretations.
B may decrease if the entrepreneur takes the long run into

consideration, i.e., has a concern for reputation.
Investment is sensitive to cash flow. If A includes the cash
flow of the past period. Firms are heterogeneous in terms
of the model’s parameters. Increasing A may trigger new
projects...
See Tirole (2006).
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Interpretations.

projects...
See Tirole (2006).
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Interpretations.

projects...
See Tirole (2006).
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Debt Overhang (1)

Study situations in which a borrower is unable to raise
funds for an otherwise profitable project, because of too
much debt.
First simple case: the borrower has a positive NPV project
that would be financed in the absence of any previous debt.
Assume that the entrepreneur owes D from previous
borrowing to “initial investors” and the entrepreneur has
signed a covenant: he(she) cannot raise more funds
without their consent. Amount A is used as collateral
(given to initial investors in case of default).
If A > A > A − D ≥ 0, the project would have been
financed without the debt D.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Debt Overhang (2)
Suppose that initial investors and new investors enter an

agreement to finance the project.
Initial investors must receive at least D in expectation
because they can seize the collateral.
The pledgeable income net of investment cost is
pH (R − B/∆p) − I. New investors obtain at most
pH (R − B/∆p) − I − D + A = A − D − A < 0.
It follows that new investors cannot break even.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Continuous-Investment Model: Assumptions (1)
Constant returns to scale. Investment I ≥ 0 yields income

RI in case of success and 0 in case of failure.
Private benefit is also proportional to investment, BI.
Entrepreneur still chooses between high or low effort.
Enjoying BI yields a lower success probability
pL = pH − ∆p < pH .
Entrepreneur borrows I − A to finance investment I.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

pL = pH − ∆p < pH .
Robert J. Gary-Bobo
Introduction
Equity Multiplier

pL = pH − ∆p < pH .
Robert J. Gary-Bobo
Introduction
Equity Multiplier

pL = pH − ∆p < pH .
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Under the loan contract, both parties receive 0 in case of

failure, and Rl and Rb resp., in case of success.
We have Rl + Rb = RI.
We assume that the project’s NPV is positive if effort is
high, that is, pH R > 1 and negative if effort is low,
1 > pL R + B.
Equilibrium investment is finite, we assume
pH R < 1 + pH B/∆p. Interpretation: expected net revenue
per unit of investment pH R − 1 is lower than expected
agency cost per unit pH B/∆p.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

1 > pL R + B.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

1 > pL R + B.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

1 > pL R + B.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
The lender’s credit analysis

The IC constraint becomes,
BI
Rb ≥ .
∆p
The IR constraint (for the lender) becomes,
pH (RI − Rb ) ≥ I − A
Competition drives the lender’s profit to zero and the

contract is the best possible for the borrower
(pH (RI − Rb ) = I − A). Thus the borrower’s expected utility
is
Ub = pH Rb − A = pH RI + A − I − A = (pH R − 1)I.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

BI
Rb ≥ .
∆p
pH (RI − Rb ) ≥ I − A

is
Robert J. Gary-Bobo
Introduction
Equity Multiplier

BI
Rb ≥ .
∆p
pH (RI − Rb ) ≥ I − A

is
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Equity multiplier (1)

Given assumptions, the borrower will invest as much as
possible (since pH R > 1).
The upper bound on I is the borrowing capacity (or debt
capacity), determined by IC and IR. Substitute IC into IR,
this yields, pH (RI − BI/∆p) ≥ I − A.
This yields I ≤ kA, where
1
k= > 1.
1 − pH (R − B/∆p)
The denominator of k is positive by assumption (made

above) and pH R > 1 > pL R + B imply R > B/∆p, so that
k > 1.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

1
k= > 1.
1 − pH (R − B/∆p)

k > 1.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

1
k= > 1.
1 − pH (R − B/∆p)

k > 1.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

1
k= > 1.
1 − pH (R − B/∆p)

k > 1.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Note: if pH is fixed, the profitability of investment is fixed.

Multiplier k is smaller the higher the private benefit B, and
the lower the likelihood ratio ∆p/pH (with pH fixed).
For the entrepreneur, it is optimal to invest I = kA,
therefore, to borrow d = k − 1 times A. Thus dA is the
maximum loan.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Note: if pH is fixed, the profitability of investment is fixed.

Multiplier k is smaller the higher the private benefit B, and
the lower the likelihood ratio ∆p/pH (with pH fixed).
For the entrepreneur, it is optimal to invest I = kA,
therefore, to borrow d = k − 1 times A. Thus dA is the
maximum loan.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
A Slightly More General Model
Assume now that profit is nonnegative in case of failure

(instead of merely zero).
This easy generalization pins down the financial structure
(debt/equity).
Let R s I be the profit in case of success and R f I the profit in
case of failure, and R f > 0.
We redefine R as R s − R f ; and R f I can be viewed as the
salvage value of assets. RI = (R s − R f )I is the increase in
profit brought about by success.
The model is otherwise the same as before.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
A Slightly More General Model (2)
We generalize the assumption about NPV per unit of

investment as follows:

s f s B
pH R + (1 − pH )R > 1 > pH R − + (1 − pH )R f
∆p
Interpretation: The NPV per unit of investment is positive.

The pledgeable income per unit of investment is negative.
A contract specifies an investment level I and a
profit-sharing rule: the borrower’s share is (Rbs , Rbf ) ≥ 0
(Rbs , Rbf ) ≥ 0 due to limited liability.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
A Slightly More General Model (3)
The optimal loan contract maximizes the entrepreneur’s

expected utility, with respect to (I, Rbs , Rbf ) ≥ 0, that is,
Maximize Ub = ph Rbs + (1 − pH )Rbf − A,
subject to the effort-incentive constraint IC:
BI
(Rbs − Rbf ) ≥ .
∆p
and the investor’s participation constraint IR,
pH (R s I − Rbs ) + (1 − pH )(R f I − Rbf ) ≥ I − A.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
The Optimal Contract (1)
The IR constraint is binding at the optimum. If not,

entrepreneur could increase Rbs and Rbf by the same > 0.
As a result, R doesn’t vary; the IC constraint doesn’t
change and Ub is increased: contradiction.
We then substitute IR as an equality, in the expression for
Ub . This yields,
Ub = (pH R s + (1 − pH )R f − 1)I.
Since we assumed pH R s + (1 − pH )R f > 1, the

entrepreneur chooses the highest I subject to IC, and IC is
binding.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Ub . This yields,
Ub = (pH R s + (1 − pH )R f − 1)I.

binding.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Ub . This yields,
Ub = (pH R s + (1 − pH )R f − 1)I.

binding.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
We can now show that Rbf = 0 is optimal.

Suppose that Rbf > 0 at the optimal contract. Consider a
small increase dRbs > 0 and a small decrease dRbf < 0
such that profitability is constant,
pH dRbs + (1 − pH )dRbf = 0.
This keeps Ub constant, but IC is now slack: a

contradiction. Therefore, Rbf = 0.
Interpretation: An all-equity firm cannot be optimal. The
entrepreneur cannot be rewarded in case of failure (the
Maximal Incentives Principle).
Robert J. Gary-Bobo
Introduction
Equity Multiplier


Robert J. Gary-Bobo
Introduction
Equity Multiplier


Robert J. Gary-Bobo
Introduction
Equity Multiplier
Interpretation as Debt Contract
Suppose that investors (lenders) hold debt D with D ≥ R f I:

this is an optimal financial structure.
In case of failure, the entrepreneur cannot reimburse D
(the firm is bankrupt). The entrepreneur obtains the
optimal payoff Rbf = 0 and the lender receives the
remainder R f I > 0.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Interpretation as Debt Contract
Suppose that investors (lenders) hold debt D with D ≥ R f I:

this is an optimal financial structure.
In case of failure, the entrepreneur cannot reimburse D
(the firm is bankrupt). The entrepreneur obtains the
optimal payoff Rbf = 0 and the lender receives the
remainder R f I > 0.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Borrowing Capacity and Equity Multiplier
Since IC and IR are both binding, we find that the

borrowing capacity I − A is given by the solution of,

B
I − A = (1 − pH )R f I + pH R s − I.
∆p
As a consequence, the equity multiplier is as follows,
A
I = kA = .
1 − (pH (R − B/∆p) + R f )
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Borrowing Capacity and Equity Multiplier
Since IC and IR are both binding, we find that the

borrowing capacity I − A is given by the solution of,

B
I − A = (1 − pH )R f I + pH R s − I.
∆p
As a consequence, the equity multiplier is as follows,
A
I = kA = .
1 − (pH (R − B/∆p) + R f )
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Predictions of the Model

Even a stylized model like Tirole’s model delivers
interesting insights.
Firms with lower agency costs can borrow more. That is,
smaller B and (or) higher ∆p imply higher I.
Investors holding safe debt plus some equity maximizes
the entrepreneur’s incentives and stake in the firm.
Decomposition: Safe debt repays R f I; expected value of
risky equity is pH (R s − R f − B/∆p)I + (1 − pH )0.
Firms with less tangible assets or with a lower value in
liquidation are firms with a small R f . These firms can
borrow less than firms with high values of R f . This is true
even if the expected profitability of investment is held
constant.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

constant.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

constant.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

constant.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Debt/Equity Ratios
As a consequence, we find the leverage ratio,
debt Rf I Rf
= =
total equity pH RI pH R
and
debt Rf I Rf
= = .
outside equity pH (R − B/∆p)I pH (R − B/∆p)
Both ratios are constant because the model is very simple.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Costly State Verification Model
This model has been analyzed by Townsend (1979) and

Gale and Hellwig (1985).
We derive the financial structure of the firm from an
optimization problem (and from primitive assumptions).
Moral hazard here comes from the fact that the
entrepreneur can divert (steal) income. There is no effort
variable here.
Income is semi-verifiable: the lenders can perfectly
observe income, provided that they incur an audit cost K .
This cost is borne by lenders.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

variable here.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

variable here.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

variable here.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Costly State Verification Model (2)
The entrepreneur invests his(her)money A. Investment

cost is I.
Investment yields a random income R distributed on
[0, +∞), with density p(R). The entrepreneur observes R
without cost.
Timing: 1. Loan agreement, I is sunk. 2. Income R is
realized. 3. Entrepreneur reports R̂. 4. Lender may decide
to audit. 5. Reimbursement.
We apply the Revelation Principle: there is no loss of
generality if we focus on revealing mechanisms, i.e.,
contracts such that the entrepreneur has an incentive to
report the true income R̂ = R.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

cost is I.
without cost.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

cost is I.
without cost.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

cost is I.
without cost.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
CSV Model (3): Definition of a Contract
A contract is a mapping giving a probability of no audit

y (R̂) ∈ [0, 1] for each report R̂, ...
and nonnegative rewards: w0 (R, R̂) and w1 (R, R̂) in the
absence or presence of an audit. The lender’s return Rl
depends on R̂ only in the absence of audit:
w0 (R, R̂) = R − Rl (R̂).
Define the entrepreneur’s expected reward under truthful
reporting w(R) = y (R)w0 (R, R) + (1 − y (R))w1 (R, R).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

w0 (R, R̂) = R − Rl (R̂).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

w0 (R, R̂) = R − Rl (R̂).
Robert J. Gary-Bobo
Introduction
Equity Multiplier
CSV Model (4): Standard Debt Contract
A standard debt contract specifies a debt level D.

There is no audit if debt D is repaid; an audit and no
reward if D is not repaid.
Formally, y (R) = 1 if R ≥ D and y (R) = 0 if R < D.
w(R) = max{R − D, 0}.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

w(R) = max{R − D, 0}.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

w(R) = max{R − D, 0}.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

w(R) = max{R − D, 0}.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
CSV Model (5): Optimal Contract

We maximize the expected income
Z +∞
Maximize w(R)p(R)dR,
0
with respect to {y (.), w0 (., .), w1 (., .)}, subject to the
entrepreneur’s incentive constraint IC , i.e.,
w(R) = max{y (R̂)w0 (R, R̂) + (1 − y (R̂))w1 (R, R̂)}

R̂
and the lender’s participation constraint, IR, that is,

Z +∞
[R − w(R) − (1 − y (R))K ]p(R)dR ≥ I − A.
0
and limited liability constraints w0 (R, R) ≥ 0, w1 (R, R) ≥ 0.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
CSV Model (5b): Optimal Contract
Since IR will be binding at the optimum, we can susbsitute IR in

the objective function (the borrower’s expected profit) and we
find,
Z +∞ Z +∞
w(R)p(R)dR = −K (1−y (R))p(R)dR−(I−A)+E(R).
0 0
The objective is equivalent to minimizing the expected audit

cost.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Analysis of the Optimal Contract (1)

Assume that audits are deterministic: y (R) = 0 or 1 for all
R.
Feasible values of R are divided into to regions: the
no-audit region Q0 and audit region Q1 (A partition of
[0, +∞)).
Reimbursement R − w(R) must be constant over the no
audit region Q0 .
Proof. If reimbursement is higher for R 0 than for R with
R, R 0 ∈ Q0 then, for R 0 entrepreneur would prefer to report
R.
Conclusion: Reimbursement must be constant, say D, if
R ∈ Q0 , and Q0 ⊆ [D, +∞).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

R.
[0, +∞)).
audit region Q0 .
R.
R ∈ Q0 , and Q0 ⊆ [D, +∞).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

R.
[0, +∞)).
audit region Q0 .
R.
R ∈ Q0 , and Q0 ⊆ [D, +∞).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

R.
[0, +∞)).
audit region Q0 .
R.
R ∈ Q0 , and Q0 ⊆ [D, +∞).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

R.
[0, +∞)).
audit region Q0 .
R.
R ∈ Q0 , and Q0 ⊆ [D, +∞).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

The reimbursement for R in Q1 cannot exceed D, for if it
did then R − w(R) > D and the entrepreneur would prefer
to report an income in Q0 to pay only D.
Important Result: for any contract satisfying IC and IR,
there exists a standard debt contract that does at least as
well for the entrepreneur.
Prove this in 2 steps.
Step 1. For any contract C, there exists a standard debt
contract C 0 that pays out more to lenders at a smaller audit
cost.
Step 2. There exists a second standard debt contract C 00
that satisfies IR (lenders break even) and involving an even
smaller expected audit cost.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

cost.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

cost.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

cost.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

cost.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Proof of Step 1. Consider an arbitrary contract C
satisfying IC and IR, with regions Q0 (no audit) and Q1
(audit). Let D be the repayment in Q0 .
Construct a standard debt contract in which repayment is
D 0 = D. Define new regions Q00 = [D, +∞) and
Q10 = [0, D).
The entrepreneur receives 0 in Q10 .
Since Q0 ⊆ Q00 , the expected audit cost is weakly smaller
(since Pr(Q0 ) ≤ Pr(Q00 )).
Expected repayment to lenders is weakly larger under C 0 :
for Q ∈ Q0 , repayment is the same, equal to D; for
R ∈ Q0 ∩ Q00 repayment is at most D under C and equal to
D under C 0 ; for R ∈ Q1 ∩ Q10 the lender’s payoff is R − K
under C 0 and cannot be larger under C.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Q10 = [0, D).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Q10 = [0, D).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Q10 = [0, D).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Q10 = [0, D).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Proof of Step 2. Suppose that the standard debt contract
C 0 leaves a strictly positive expected profit to lenders.
Then, by the intermediate value theorem, there exists
D 00 < D such that the lenders’ payoff is just 0,
Z D 00
00 00
[1 − P(D )]D + Rp(R)dR − P(D 00 )K = I − A,
0
where P(D 00 ) = Pr(R ≤ D 00 ) is the cdf of p.

Contract C 00 has a lower expected audit cost since
D 00 < D 0 = D, implying P(D 00 )K < P(D 0 )K and leaves no
surplus to lenders (IR is an equality).
We conclude that contract C 00 is preferred by the borrower
to the initial contract C.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Z D 00
00 00
[1 − P(D )]D + Rp(R)dR − P(D 00 )K = I − A,
0

Robert J. Gary-Bobo
Introduction
Equity Multiplier

Z D 00
00 00
[1 − P(D )]D + Rp(R)dR − P(D 00 )K = I − A,
0

Robert J. Gary-Bobo
Introduction
Equity Multiplier
Figure 1: Borrower’s reward

_
~
o~
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Figure 2: Lender’s reward

1
~
~~~~----------~----~~
~
1
~I --
~
~
~
~
"'"
D -
~
~C)
f\)
,
Robert J. Gary-Bobo
Introduction
Equity Multiplier
CSV Model: Interpretation

The audit region Q1 is interpreted as bankruptcy region.
When R < D, the entrepreneur fails to reimburse the debt
and is declared bankrupt.
The entrepreneur can withdraw nothing from the "cash
register" before the audit, but can fully withdraw the
residual income if there is no audit.
Interpretation: the borrower can in fact steal the income
but cannot consume it and must refund it if an audit takes
place.
Alternative interpretation: the entrepreneur can, over time,
transform hidden income into perks. Perks can be enjoyed
if the firm is not shut down. During the bankruptcy process,
the lenders recoup the value of the assets in the firm.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

place.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

place.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

place.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
The Non-Verifiable Income Model
We now study the polar case in which the firm’s income is

not observable, even by means of an audit.
The borrower can consume the income with complete
impunity.
The borrower’s incentive to repay comes from the threat of
termination.
This model has been studied by Bolton and Sharfstein
(1990) and Gromb (1994).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

impunity.
termination.
(1990) and Gromb (1994).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

impunity.
termination.
(1990) and Gromb (1994).
Robert J. Gary-Bobo
Introduction
Equity Multiplier

impunity.
termination.
(1990) and Gromb (1994).
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Non-Verifiable Income: Assumptions
We consider two dates only (extensions are possible).

At date 1, the investment is I, yields income R1 with
probability p and 0 with probability 1 − p.
At date 2, the initial investment, if not terminated, yields
expected income R2 to the entrepreneur.
The entrepreneur repays nothing at date 2 (since this is the
last period) as long as return 0 is a possibility (otherwise
the entrepreneur repays the minimal value of second
period income). R2 can be treated as a deterministic
private benefit.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

private benefit.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

private benefit.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

private benefit.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Non-Verifiable Income: Assumptions (2)
If the project is liquidated at date 1, the lenders receive

liquidation value L; we assume 0 ≤ L ≤ I − A.
Assume L < R2 , i.e., liquidation is inefficient.
There is no discounting (for simplicity).
We now look for the optimal contract, that maximizes the
borrower’s expected payoff subject to IC and IR.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

Robert J. Gary-Bobo
Introduction
Equity Multiplier

Robert J. Gary-Bobo
Introduction
Equity Multiplier

Robert J. Gary-Bobo
Introduction
Equity Multiplier
Non-Verifiable Income: Analysis (1)

The entrepreneur obviously repays 0 if the first-period
return is 0.
Let y0 ∈ [0, 1] denote the probability of continuation when
there is no repayment at date 1. So 1 − y0 is the probability
of termination.
Consider a contract that specifies a repayment equal to
D ≤ R1 if first-period income is equal to R1 , together with a
probability of continuation y1 if D is repaid.
The repayment of D must be incentive compatible,
R1 − D + y1 R2 ≥ R1 + y0 R2 .
This is equivalent to (y1 − y0 )R2 ≥ D.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

return is 0.
of termination.
R1 − D + y1 R2 ≥ R1 + y0 R2 .
Robert J. Gary-Bobo
Introduction
Equity Multiplier

return is 0.
of termination.
R1 − D + y1 R2 ≥ R1 + y0 R2 .
Robert J. Gary-Bobo
Introduction
Equity Multiplier

return is 0.
of termination.
R1 − D + y1 R2 ≥ R1 + y0 R2 .
Robert J. Gary-Bobo
Introduction
Equity Multiplier
The optimal contract solves the following program.
Maximize {p(R1 − D + y1 R2 ) + (1 − p)(y0 R2 )}
with respect to (y0 , y1 , D), subject to IC,
(y1 − y0 )R2 ≥ D,
and IR,
p[D + (1 − y1 )L] + (1 − p)(1 − y0 )L ≥ I − A
and D ≤ R1 .
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Assume first that R1 is large, so that D ≤ R1 is not binding.

We first show that IR must be binding. Otherwise, the debt
D could be lowered while keeping IC and IR satisfied, and
D cannot be equal to 0 since L < I − A.
We then have y1 = 1, i.e., no liquidation in case of
repayment. If 1 > y1 > y0 , increase y1 by ε > 0 and raise
D by εL to keep IR satisfied. IC remains satisfied since
R2 > L. The borrower’s utility increases by p(R2 − L)ε > 0;
contradiction.
Conclusion: Liquidation in case of repayment is bad for
efficiency and incentives, so y1 = 1.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

contradiction.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

contradiction.
Robert J. Gary-Bobo
Introduction
Equity Multiplier

contradiction.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
We now prove that IC too must be binding.

Note that we must have y0 < 1 = y1 . If IC is not binding,
raise y0 by a small ε > 0, and increase D by εL(1 − p)/p;
IR is still satisfied; IC remains satisfied if ε is sufficiently
small.
The borrower’s expected utility increases by

ε(1 − p)L
−p + (1 − p)εR2 = (1 − p)(R2 − L)ε > 0.
p
Robert J. Gary-Bobo
Introduction
Equity Multiplier

small.

ε(1 − p)L
−p + (1 − p)εR2 = (1 − p)(R2 − L)ε > 0.
p
Robert J. Gary-Bobo
Introduction
Equity Multiplier

small.

ε(1 − p)L
−p + (1 − p)εR2 = (1 − p)(R2 − L)ε > 0.
p
Robert J. Gary-Bobo
Introduction
Equity Multiplier
Non-Verifiable Income: The Optimal Contract
Conclusion: IC is binding at the optimum and since y1 = 1,

we have (1 − y0 )R2 = D.
From IR we derive, pD + (1 − p)(1 − y0 )L = I − A.
We can solve this system for y0 and D. We find,
R2 (I − A)
D= ,
pR2 + (1 − p)L
and
I−A
1 − y0 = .
pR2 + (1 − p)L
Robert J. Gary-Bobo
Introduction
Equity Multiplier

we have (1 − y0 )R2 = D.
R2 (I − A)
D= ,
pR2 + (1 − p)L
and
I−A
1 − y0 = .
pR2 + (1 − p)L
Robert J. Gary-Bobo
Introduction
Equity Multiplier

we have (1 − y0 )R2 = D.
R2 (I − A)
D= ,
pR2 + (1 − p)L
and
I−A
1 − y0 = .
pR2 + (1 − p)L
Robert J. Gary-Bobo
Introduction
Equity Multiplier
The Optimal Contract: Interpretation
The threat of termination provides incentives for repayment

when income is nonverifiable.
Termination is less likely if,
(a), R2 is larger (the borrower has more to lose);
(b), L is larger (lenders can liquidate less often since they
on average obtain more from liquidation);
(c), the probability p increases;
(d), the borrower’s net worth A increases.
Robert J. Gary-Bobo
Introduction
Equity Multiplier
The Optimal Contract: Interpretation
The threat of termination provides incentives for repayment

when income is nonverifiable.
Termination is less likely if,
(a), R2 is larger (the borrower has more to lose);
(b), L is larger (lenders can liquidate less often since they
on average obtain more from liquidation);
(c), the probability p increases;
(d), the borrower’s net worth A increases.
Robert J. Gary-Bobo

Cours Corporate Finance

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Cours Corporate Finance

Hochgeladen von

Copyright:

Verfügbare Formate

Introduction

Tirole’s Simple Credit Rationing Model

Ecole Polytechnique, 2015

We propose here a first elementary study of credit

We first study Tirole’s (2006) simple model of credit. (See

Basic Assumptions (1)

Basic Assumptions (2)

If undertaken the project either succeeds: verifiable

The entrepreneur can exert high effort (work, take no

Basic Assumptions (4)

Borrower and lenders (investors) are risk-neutral.

The loan contract specifies how the profit is shared

Basic Assumptions (6)

pH R − I > 0 and pL R − I + B < 0.

No loan giving an incentive to low effort will be granted:

The lender’s credit analysis (1)

The borrower’s tradeoff: obtain private benefit B but reduce

The highest income that can be pledged to lenders is

The lender’s credit analysis (2)

Financing can be arranged only if

We assume that I > pH (R − B/∆p).

The lender’s credit analysis (3)

The borrower must have enough assets

The lender’s credit analysis (4)

The entrepreneur offers the minimal claim Rl , such that

so that the entrepreneur chooses high effort.

Determinants of credit rationing

What are the determinants of credit rationing?

Do investors hold debt or equity?

Remark that the loan contract can be interpreted as debt

B may decrease if the entrepreneur takes the long run into

B may decrease if the entrepreneur takes the long run into

B may decrease if the entrepreneur takes the long run into

Debt Overhang (1)

Debt Overhang (2)

Suppose that initial investors and new investors enter an

It follows that new investors cannot break even.

Continuous-Investment Model: Assumptions (1)

Constant returns to scale. Investment I ≥ 0 yields income

Continuous-Investment Model: Assumptions (1)

Constant returns to scale. Investment I ≥ 0 yields income

Continuous-Investment Model: Assumptions (1)

Constant returns to scale. Investment I ≥ 0 yields income

Continuous-Investment Model: Assumptions (1)

Constant returns to scale. Investment I ≥ 0 yields income

Continuous-Investment Model: Assumptions (2)

Under the loan contract, both parties receive 0 in case of

Continuous-Investment Model: Assumptions (2)

Under the loan contract, both parties receive 0 in case of

Continuous-Investment Model: Assumptions (2)

Under the loan contract, both parties receive 0 in case of

Continuous-Investment Model: Assumptions (2)

Under the loan contract, both parties receive 0 in case of

The lender’s credit analysis

The IR constraint (for the lender) becomes,

Competition drives the lender’s profit to zero and the

The lender’s credit analysis

The IR constraint (for the lender) becomes,

Competition drives the lender’s profit to zero and the

The lender’s credit analysis

The IR constraint (for the lender) becomes,

Competition drives the lender’s profit to zero and the

Equity multiplier (1)