The optimal financing of a conglomerate firm with hidden information and costly state verification

Abstract

This manuscript addresses the issue, particularly interesting for a conglomerate firm, of the choice of the optimal financing method (namely, the most efficient one) between the joint one and the separate one. In particular, the authors identify the properties of the optimal financing contract for three investment projects under the assumptions of the literature on Costly State Verification (CSV), namely, uncorrelated returns, hidden information (the return of a single project is a borrower’s private information), lender performing sequential audit and residual claimant borrower. The authors’ research method consists of solving the optimization problem of the borrower’s expected utility subject to appropriate incentive constraints and the lender’s participation constraint. The novelty of this contribution is the demonstration that joint financing with return pooling between the high and low states is more efficient than separate financing, as it implies a lower expected audit cost for the lender and, if the investment cost is not too high, also less credit rationing for the borrower. Joint financing with return pooling between the intermediate and low states, instead, is found to be less efficient than separate financing in terms of expected audit cost and, in the presence of sufficiently high investment cost, also credit rationing.