Optimal Long-Term Financial Contracting with Privately Observed Cash Flows

We characterize the optimal long-term financial contract in a setting in which a risk-neutral agent with limited capital seeks external financing for a project which pays stochastic cash flows over many periods. These cash flows are unobservable and unverifiable by outside investors. The agent can be induced to pay investors via the threat of the loss of control of the project. After solving for the contract as an optimal mechanism, we demonstrate that it can be implemented by a combination of standard forms of long-term debt contracts. So we have a theory of long-term debt financing. Our analysis covers both the case in which the agent and investor can commit to a contract and the case in which contracts can be renegotiated. † We would like to thank Mark Garmaise and Denis Gromb for helpful comments and discussions. * Stanford, CA 94305. Phone: (650) 736-1082, Email: [email protected]. * Evanston, IL 60208. Phone: (847) 491-8332, Email: [email protected].