SFB 303 Discussion Paper No. A - 202

Author: Weskamp, Anita
Title: Incentive Compatible Credit Contract of a Two-Product Firm
Abstract: In a recent paper D. Gale and M. Hellwig (1985) have shown that costly ex post verification by creditors may explain the frequent use of credit contracts with a fixed repayment value and a bankruptcy clause. Their analysis starts from the assumption that the creditor may choose to control the whole firm or nothing at all. In reality, bankruptcy implies that a long list of inputs, outputs, machinery and real estate is controlled and finally sold. Hence, this paper investigates whether the "all or nothing" control strategy implied by a standard debt contract is a optimal given that partial control is admissible. The results indicate that in general this is not the case. Instead, there exists a class of weakly dominating contracts, which includes the standard debt contract but which contains a much larger set of contracts. It will be shown that all these contracts exhibit some of the properties of the standard debt contract.
Creation-Date: October 1988
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