We provide a new justification for the widespread use of debt finance as an alternative to equity finance. We show that when the returns of investment projects can only be partially observed by outside financiers, and this partial observation is itself costly, then the optimal contract agreed between entrepreneurs and outside financiers takes the form of a standard debt contract.
This finding builds on existing literature that had shown the benefits of debt finance in settings where outside financiers were either unable to commit to future audit strategies, or were unable to implement audit strategies with randomization. Our model builds on this literature by extending the prediction of debt finance as optimal to a wider range of settings, helping to match empirical regularities.
We produce numerical estimates of contract terms for a simulated version of the model; we show that the model can reproduce key features of the data including leverage, interest rate spreads, and probabilities of default. We also show that in a special case of our model, closed form solutions for leverage and interest rate spreads can be described in terms of model parameters.
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