Optimal Entrepreneurial Financial Contracting

Ebrahim, Muhammed-Shahid; Mathur, Ike

Abstract

This paper studies the optimal financing (capital structure) of entrepreneurial activity in the context of risk-aversion by incorporating the deadweight costs of bankruptcy and taxes. Unlike the extreme debt ratio (corner solution) predicted by scholars using linear models, this paper provides unique interior results for risk-free as well as risky debt, irrespective of corporate taxes. The paper also shows the necessary and sufficient conditions for both forms of debt, and the pareto-optimality of one over the other. The important findings of this paper are: (i) the existence of an equilibrium, where the borrowing interest rate is greater than the lending rate, despite the violation of Fisher separation theorem (1930); (ii) wealth plays a critical role in determining the debt ratio and the equilibrium risk-free rate of interest, complementing the De Meza and Webb (1987 and 1999) studies; (iii) an explanation for the preferred stock and income bond puzzles, extending Fooladi et al. (1991) and McConnell and Schlarbaum (1991).

Citation

Ebrahim, M., & Mathur, I. (2000). Optimal Entrepreneurial Financial Contracting. Journal of Business Finance and Accounting, 27(9-10), 1349-1374. https://doi.org/10.1111/1468-5957.00360

• Journal Article Type: Article
• Publication Date: 2000-11
• Deposit Date: Sep 25, 2014
• Journal: Journal of Business Finance and Accounting
• Print ISSN: 0306-686X
• Electronic ISSN: 1468-5957
• Publisher: Wiley
• Peer Reviewed: Peer Reviewed
• Volume: 27
• Issue: 9-10
• Pages: 1349-1374
• DOI: https://doi.org/10.1111/1468-5957.00360
• Public URL: https://durham-repository.worktribe.com/output/1423230