SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

Abstract: We present a model of financial contracting in the presence of asymmetric information between entrepreneur and investor. Either liquidation threat or governance control can be used to protect investor’s interests against expropriation risk. The two parties first agree to a financial arrangement which assigns to the parties the ”governance right” to choose the level of governance control and the ”contracting right” to design the financing contract. We show the trade-off between costs of liquidation and governance control determines the equilibrium. In Pareto-efficient equilibrium financial arrangements, a highly profitable project is financed by a contract which relies on liquidation threat so that liquidation occurs with a strictly positive probability. On the other hand, a less profitable project relies on governance control, thereby avoiding liquidation altogether. We relate different equilibrium financial arrangements to the ownership and financial structure of firm.

Keywords: Asymmetric information; liquidation; governance control

JEL-codes: D82; G32

26 pages, April 1997

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