R&D, Capital Investments, and Financing under Repeated Moral Hazard

This paper considers the impact of finance on growth by exploring a model where entrepreneurs need both outside investors to provide funds and outside managers to operate the firm efficiently once assets are in place. We employ a repeated game framework which allows us to model outside equity as well as inside equity and debt. Our framework captures the stylized fact that the insider who can contribute most to the firm at one stage of its development may well become a source of under-performance later. In our framework we identify several distinct obstacles to achieving efficiency. First, the firm’s assets may be operated inefficiently. Second, positive NPV projects may not be undertaken because they ate unable to obtain sufficient outside finance. Third, positive NPV projects which could obtain outside finance may not be undertaken because the returns to R&D are too low. A key difference between debt and equity are the different control rights they bestow upon outside investors. In the absence of uncertainty, debt financing trends to promote managerial entrenchment and the creation of growth opportunities, at the expense of efficiency once the firm is up and running. Equity financing has the opposite effect. We find that there is no robust “pecking order” of financial contracts. However, in the differential abilities model, we find that debt tends to (weakly) dominate when outside managerial moral hazard is “high” and interest rates are “low”; whereas equity tends to (weakly) dominate when outside managerial moral hazard is “low” and interest rates are “high”.