OVERINVESTMENT AND OVERBORROWING UNDER THE DEBT CONTRACTS

Abstract

In the presence of asymmetric information between a lender and a borrower with costly monitoring, we investigate a contract form and an optimal loan size are investigated. The optimal contract has the features of a standard debt contract. However, the optimal loan size does not always take the form of maximum equity participation. If per unit of return from lending is a decreasing function of the loan size, the contract takes the form of maximum equity participation. Conversely, if per unit of return from lending is an increasing function of the loan size, overinvestment or overborrowing may arise.