Investor Protection and Optimal Contracts under Risk Aversion and Costly State Verification

We present a model of firm finance that encompasses imperfect investor protection, risk aversion and costly state verification. We characterize optimal contracts and study the conditions under which standard debt is optimal. Under suitable assumptions about the structure of the problem, standard debt contracts (SDCs) are optimal if and only if investor protection is sufficiently low. On the other hand, low investor protection results in higher funding costs and bankruptcy probabilities. In our setting, this implies that when SDCs are optimal, lowering investor protection reduces the entrepreneur’s welfare. Numerical examples show that moderate changes in investor protection can have large effects on the terms of the contract and on the entrepreneur’s welfare. Finally, we study the role of leverage and consider the welfare consequences of suboptimally implementing standard debt contracts. Copyright Springer-Verlag Berlin Heidelberg 2015

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