Realized revenue in period t is given by ωitRtkQt-1Kit,whereωit ∈ R+ is an i.i.d.
(across firms and time) productivity disturbance with the probability density function
f (ω) and E [ωit] = 1 for all t. Because the entrepreneur has insufficient net worth
to finance the entire capital investment, he must obtain a loan from a risk-neutral
financial intermediary. Letting Nit-1 denote the entrepreneur’s net worth at the end
of period t - 1, he borrows Bit-1 to purchase the requisite amount of capital:
Bit-1 + Nit-1 = Qt-1Kit.
The entrepreneur’s profit is then given by
ωitRtkQtKit - RibtBit-1,
where Ribt is the contractual gross interest rate paid on the loan amount Bit-1 .
To fund loans, the intermediary raises funds at the risk-free gross interest rate
Rt ≤ Rtk . If the lender had complete information about the idiosyncratic shock
ωit , arbitrage would ensure that in equilibrium Rtk = Rt . The lender, however, can
only observe ωit by paying a “monitoring cost,” assumed to be proportional to the
realized revenue from the project. In particular, if the borrower claims an adverse
productivity shock and defaults on his debt obligations, the lender, after verifying
the entrepreneur’s claim, receives residual revenue equal to
(1 - μ)ωitRkQt-1 K-.
where 0 < μ < 1 measures costs associated with bankruptcy proceedings.5
The presence of bankruptcy costs and asymmetric information about the firm-
specific productivity shock creates an incentive for the entrepreneur to claim default
in situations when the realized productivity is high. Reflecting these agency prob-
lems, the incentive-compatible debt contract between the lender and entrepreneur
stipulates a productivity threshold such that if the realized productivity is above the
threshold, the borrower repays the loan and keeps the remainder of the revenue from
the project. If, however, the realized productivity falls below the specified thresh-
5As argued by Smith and Stromberg (2003), the main purpose of corporate bankruptcy law is to
mitigate bargaining frictions when a firm is in financial distress. These frictions necessarily entail
costs to the lender that include, but are not limited to, the verification of assets and liabilities, the
protection of assets during bargaining among claimants, and costs of liquidating the firm’s assets.