Financial Constraints And Firm Dynamics In Continuous Time

The principal-agent problem limits entrepreneurs'borrowing capacity and consequently may be one of the important determinants of firm dynamics. In this thesis,we consider a long-term debt contract in continuous time between a risk-neutral entrepreneur with lim-ited endowment of wealth,who has the opportunity to invest in a project,and a risk-neutral investor with unlimited wealth. With asymmetric information, we characterize the optimal long-term debt contract contingent upon the entrepreneur's continuation value. We use a martingale approach to formulate the entrepreneur's incentive compatibility constraint, and characterize the optimal contract through an ordinary differential equation. Such continu-oustime setting offers several advantages. Firstly, it yields at least a partly explicit determi-nation of the firm dynamics. Secondly, it allows us to compute the evolution of firm size distribution.The optimal long-term debt contract consists of the investment level, allocation pol-icy,and liquidation policy, and rewards and punishes to discipline the entrepreneur's con-duct. Therefore, the optimal contract determines the nontrivial diffusion processes for firm dynamics.Production shocks affect the firm's financial structure, thus have persistent effects on the firm dynamics. In agreement with the empirical evidence, we show that firm growth rate and its volatility and the survival probability decrease with the firm size and age. In addition, the model is able to generate the evolution of skewness in firm size distribution documented by recent empirical work.