It is well known that a debt contract provides strong incentives to a borrower who is holding residual claims to exert high levels of effort. This result carries over to the case when the borrower seeks funds for multiple projects where now the lender can use cross-pledging to further enhance incentives. More specifically, the lender can now condition the borrower’s reward on the joint performance of all projects.
In this Nottingham School of Economics working paper Spiros Bougheas and Tianxi Wang consider the case of multiple project finance when the borrower also has better information than the lender about the contribution of her effort on each project’s success. The main result of the paper is that when the borrower cannot improve the likelihood of success of some projects by exerting effort cross-pledging can destroy incentives to exert effort even on those projects that can benefit from such effort. Then when at the time when the contract is signed there is a high likelihood that the portfolio of projects might be a mix of both types then the optimal finance response is outside equity which offers incentives to the borrower to exert effort whenever a project can benefit from it. The paper also shows that providing maximal incentives is not always optimal.
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Spiros Bougheas and Tianxi Wang
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