Optimal Financial Contracting and Risk-Shifting

I study optimal financial contracting when neither cash flows nor the risk profile of project choices are verifiable. Using a contracting framework, I show the resulting two frictions (cash-diversion and asset-substitution) are intricately linked: to address the cash-diversion problem, an optimal contract resembles a debt contract, which in turn causes the asset-substitution problem. A key finding of this paper is that, due to the potential shift of control rights to the investor, the firm does not have an excessive risk-taking incentive; in fact, my model predicts that the firm may choose an excessively safe risk-profile. Also, my model highlights the role of the financial market structure (private vs. public debt): the asset substitution problem increases the cost of public debt, but lowers that of private debt. Strikingly, however, regardless of the market structure, the asset-substitution problem leads to a more efficient risk-profile choice.