Year of Graduation
Moral Hazard, Liquidity and Costly Investment
This paper is devoted to a moral hazard problem in project and firm financing. The classical agent-principal problem assumes that the principal has a task, which can be done by the agent. The success of this task depends on how much costly effort was exerted by the agent, so the principal gives compensation for the agent to cover these costs. The moral hazard problem arises when the principal cannot observe actions of the agent. However, he can observe another variable that is only an imperfect signal of the agent’s effort. In case of financial contracts such signal is performance of the project, for example, profit, share in the market or growth. The principal object is to maximize his own income, so he proposes a contract to motivate the agent to work harder. The contract specifies the compensation for the agent conditional on the observable variable that is imperfectly correlated with the agent’s actions. In this paper we tried to compare classical model with the modified model, which is designed to follow the problem of moral hazard in project and firm financing. The classic model does not fit perfectly the problem of venture financing since the agent is penniless and receives compensation only after the realization of the project. However, venture firms often deal with significant amount of funds invested in the beginning of the project lifecycle. To adapt the classic model the compensation for the agent was divided into two parts. First part, as in the classic model, is received after the realization on profits depending on the project performance. The second part is considered as initial investment that is specified in the contract and is received before the project starts. It is also considered that the financing of the project and the chosen level of effort should be aligned. Scarce investment makes even high effort inefficient, while excess financing induces the agent to steal a part of funds. While this additional initial investment makes the modified model closer to the real world project financing simulation it also makes the model less efficient comparing to the classic one. The allocation of initial financing is an additional source of information rent, which should be paid by the investor. Therefore, in case the investor has all bargaining power, the overall effort and project value becomes less in the modified model. However, the shift of bargaining power to the agent makes her exert higher effort and increase efficiency. The only drawback is that this approach decreases the investor’s return of capital, which is, however, a familiar effect of rising efficiency on financial markets. The case when all the bargaining power belongs to the agent corresponds with perfectly competitive financial markets. Therefore, the real life project values lay somewhere in between the two extreme cases: all bargaining power on the entrepreneur’s side and all bargaining power on the investor’s side.