Optimal Debt Contracts with Renegotiation

Abstract

This paper sutudies the role of debt in committing a seller not to trade at a low price. We consider a discrete‐time finite‐horizon buyer–seller relationship. The seller makes an upfront relationship‐specific investment, which is financed with debt. Debt then is repaid gradually to mitigate the hold‐up risk. Even though debt is renegotiable, under the assumption that with a small probability renegotiation may fail and may lead to inefficient liquidation, debt still can be used as a commitment device. We solve for renegotiation proof dynamic debt contracts that are optimal for the seller and show that debt is repaid over the entire course of the relationship with declining repayments.

Rent-sharing, Holdup, and Wages: Evidence from Matched Panel Data

“…This builds on an insight about the value of pre-committing to debt inBrander and Lewis (1986). As noted byUsman (2004), an implicit assumption is that renegotiation with creditors is costly in the event of no agreement. We are grateful to Bentley MacLeod for helpful discussions on the potential importance of debt in avoiding holdup.31 Debt financing requires costly monitoring by lenders and may introduce its own moral hazard problems between managers and debt holders(Myers, 1977;Dasgupta and Sengupta, 1993).…”