Edited by Peter G. Klein and Michael E. Sykuta
Chapter 24: Financial-Market Contracting
Dean V. Williamson Should a firm finance a project with non-recourse debt – that is, with debt that affords creditors recourse to nothing more than the project-specific assets in the event of default? Alternatively, should the firm finance a project with corporate-level debt – that is, with debt that affords creditors recourse to other assets in the firm? Should the firm even finance the project with infusions from equity investors? Finally, should the firm adopt a ‘financial structure’ that features a combination of debt and equity financing? These questions suggest that the firm might perceive tradeoffs in adopting one financial structure over another. While it may be easy enough to pose tradeoffs, characterizing optimal structures is a rich and interesting problem. To begin, the irrelevance theorems of Modigliani and Miller (1958) indicated that one can identify environments in which no particular structure dominates in equilibrium. The results motivated prodigious streams of research about how different structures can dominate, yet, forty years on Hart and Moore (1998, p. 1) could still observe that ‘economists do not yet have a fully satisfactory theory of debt finance (or of the differences between debt and equity)’. To fix ideas, consider the decision of one entity (the ‘firm’, say) to finance a discrete project with a financial contract called ‘debt’ by which the firm yields to another party (the ‘investor’) a non-contingent stream of payments and a right to foreclose – that is, with the right to march in and demand the redeployment of assets in the...
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