Equity Markets and Economic Development: What Do We Know



VE =


r(EMV)-


pa(α)
r (EMV )


* pk1 + φ


(5)


Turning to debt contracts, the bank’s expected outcome is r[zpD+ (1 - z)npk2]. Using the
lender’s participation constraint, this is equivalent to:

D = [pa (α )- r (1- z )npk 2 ]

(6)


rzp

With probability p , the firm is successful, repays the loan and retain control over output
production
Φ . With probability (1 - p), the firm fails, goes bankrupt and produces a
subsistence amount of home production
φ. The firm’s expected net income can thus be
defined as
VD = rp(k1 -D)+ pΦ + (1 - p)φ. By substitution, we have:

VD = [r (em )- pa {g )] + p φ + (1 - p φ

(7)


zt

The optimal choice of contract for a type-1 firm can then be characterized by the function

V* = VE - VD ; that is, from (5) and (7):

(1 - p)(1 )- [r (emv - pa(α))](1- z)npk2 = 0

(8)


V ʌ 7          z (EMV )

An equity contract is chosen if VE- VD0, while a debt contract is chosen if VE- VD0 .
For each level of efficiency
α (0,1) , it can be shown that V * is a concave function in
z (0,1) , with limz0 V* = +∞ and limz1 V* = (1 - p)(Φ -φ) 0 .



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