Sunday, May 8, 2005
It is axiomatic that debt and equity investors in a firm have different risk profiles and hence different objectives. Can contract law be used to help bridge those differences? In a new paper, A Contribution to the Theory and Practice of Rational Financial Contracting, Wisconsin business school prof Robert E. Krainer tries to develop a model of an "optimal bond contract" that might help do that. Click on "continue reading" for the abstract.
The objective of this paper is to develop a model of an optimal bond contract that binds differentially risk averse debt and equity investors together in the firm. Towards this end, a nontraditional equilibrium model of a debt and equity financed firm is developed that motivates the need for an up-front bond contract. The equilibrium for this model is characterized by a no arbitrage condition both within the different segments of the capital market (eg., the bond and stock market), and between the capital market and the product/factor market. The model bond contract guides the firm towards this equilibrium by directing managers to make investment decisions that conform to the risk aversion of their shareholders as revealed in equity share prices, and then to make financing decisions that preserve the investment quality of their bonds. This is achieved in a two part covenant: i) linking long-term debt to the firm's investment in net working capital; and ii) conditioning the cash payments to shareholders on the amount of slack in the first part of the covenant. Matched covenants like these are shown to coalesce the intertemporal welfare of bondholders and stock holders.