Financial contracting under imperfect enforcement

Abstract

We develop a model of financial contracting under imperfect enforcement. Financial contracts are designed to keep entrepreneurs from diverting project returns, but enforcement is probabilistic and penalties are limited. The model rationalizes the prevalence of straight debt and common stock, and its predictions are consistent with a host of empirical capital structure regularities. © The Author(s) 2011. Published by Oxford University Press, on behalf of President and Fellows of Harvard College. All rights reserved.