The U-shaped Investment Curve: Theory and Evidence

This paper examines how the investment of financially constrained firms varies with their level of internal funds. We develop a theoretical model of optimal investment under financial constraints. Our model endogenizes the costs of external funds and allows for negative levels of internal funds. We show that the resulting relationship between internal funds and investment is U-shaped. In particular, when a firm's internal funds are negative and sufficiently low, a further decrease leads to an increase in investment. This effect is driven by the investor's participation constraint: when part of any loan must be used to close a financing gap, the investor will provide funds only if the firm invests at a scale large enough to generate the revenue that enables the firm to repay. We test our theory using a data set with close to 100,000 firm-year observations. The data strongly support our predictions. Among other results, we find a negative relationship between measures of internal funds and investment for a substantial share of financially constrained firms. Our results also help to explain some contrasting findings in the empirical investment literature.Financial constraints, capital market imperfections, financial contracts, investment, internal funds, investment-cash flow sensitivity

Booms, Busts, and Fraud

We examine firm managers' incentives to commit fraud in a model where firms seek funding from investors and investors can monitor firms at a cost in order to get more precise information about firm prospects. We show that fraud incentives are highest when business conditions are good, but not too good: in exceptionally good times, even weaker firms can get funded without committing fraud, whereas in bad times investors are more vigilant and it is harder to commit fraud successfully. As investors' monitoring costs decrease, the region in which fraud occurs shifts towards better business conditions. It follows that if business conditions are sufficiently strong, a decrease in monitoring costs actually increases the prevalence of fraud. If investors can only observe current business conditions with noise, then the incidence of fraud will be highest when investors begin with positive expectations that are disappointed ex post. Finally, increased disclosure requirements can exacerbate fraud. Our results shed light on the incidence of fraud across the business cycle and across different sectors.Boom, Credit Cycle, Fraud, Monitoring

Financial contracts, bankruptcy and product market competition

This thesis consists of three self–contained game–theoretic analyses of the contractual relationship between borrowers and lenders. A key element of this relation concerning their strategic variables than their opponents. Optimal contracts for different environments are derived and studied. They include ‘bankruptcy’ games, which are designed to structure the parties’ bargaining under certain circumstances. The first chapter questions the idea that being a unique lender to a firm is better than sharing the lender’s role. Even borrowers with poor prospects will apply for loans, if their main goal is to be financed, and re–financed if necessary. With one lender, refinancing is always provided once former loans are ‘sunk’. With two lenders, the situation may be different: inefficient negotiations have to determine how the overall loss is allocated. Some borrowers may therefore not be refinanced, and this may keep borrowers with poor prospects from applying for loans. The second chapter extends this model by adding a timing dimension: a borrower finds out about poor prospects earlier than his lender. He can ask for refinancing, or simply ‘wait and pray’. Either ‘soft’ contracts or ‘tough’ contracts may be optimal contracts: ‘soft’ contracts treat the borrower well if he asks for refinancing, while ‘tough’ contracts don’t (and the lender will not have the option of refinancing). ‘Hybrid’ contracts are strictly worse than the two ‘pure’ types. From this we draw conclusions for the design of bankruptcy laws, and for empirical work on bankruptcy. The third chapter analyses the interdependence of financial and production decisions. Debt contracts are frequently thought to lead to excessive risk taking — in a Cournot setup this means excessive production. At the same time, debt is a costly type of financing, which should reduce production. This conflict is analysed in a setting which allows to endogenise ‘debt’ contracts. The main result is that there is no excessive production, and financial constraints reduce output. However, for large levels of ‘inherited’ debt, it may be that output increases in the level of debt