Capital Structure and Risk Management

This paper examines the impact of capital structure on the optimality of contingent financial contracts. The role of financial relationships is not only to provide funds but also to offer insurance to a risk adverse entrepreneur through contingent financial transfers. Since such financial relationships are long term, the question is on the depth of the financier's commitment to continue to offer financing in the future. If such a commitment cannot be obtained, insurance cannot be perfect. In that case, the entrepreneur chooses to complement outside insurance with internal financing. Depending on the financier's property rights on the firm's assets, the use of reserves can relax the financing constraints and considerably improve not only the level of insurance obtained through the contract but also the efficiency of investment decisions. This rationalizes the use of convertible debt in venture capital relationships.
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