Default And Renegotiation: A Dynamic Model Of Debt

We analyze the role of debt in persuading an entrepreneur to pay out cash flows, rather than to divert them. In the first part of the paper we study the optimal debt contract-specifically, the trade-off between the size of the loan and the repayment-under the assumption that some debt contract is optimal. In the second part we consider a more general class of (nondebt) contracts, and derive sufficient conditions for debt to be optimal among these. © 2000 the President and Fellows of Harvard College and the Massachusetts Institute of Technology