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The Loan Commitment as an Optimal Financing Contract

Published online by Cambridge University Press:  06 April 2009

Elazar Berkovitch  and
Stuart I. Greenbaum
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Abstract

This paper provides an imperfect information explanation for the existence of bank loan commitments when both the bank and the potential borrower are risk neutral. The borrower is assumed to have access to a two-stage investment project wherein the investment required in the second stage is not known at the outset. The unknown investment requirement is revealed to the borrower, but not to the bank, at the beginning of the second stage. If the investor borrows at the beginning of the first stage, the realization at the beginning of the second stage might prompt a default in a situation where the project yields positive net present value. The reason is that the borrower does not regard the first-stage investment as a sunk cost. We show that a two-stage contract resembling a loan commitment can solve this under-investment problem.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 26 , Issue 1 , March 1991 , pp. 83 - 95
Copyright
Copyright © School of Business Administration, University of Washington 1991

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