Anticipating Disagreement in Dynamic Contracting

Anticipating Disagreement in Dynamic Contracting
John Y Zhu
Review of Finance, Volume 26, Issue 5, September 2022, Pages 1241–1265,

The emergence of disagreement is a significant friction in long-term financing relationships. This paper studies a long-term optimal contracting problem between a financier and an entrepreneur, in which it is anticipated that, at some point in the future, disagreement might emerge about which action the entrepreneur should take. The financier is uncertain about the nature of future disagreement and is averse to this uncertainty.

The financier’s uncertainty-aversion to anticipated disagreement has a differential impact on asset prices. The financier’s valuation of debt is uniquely immune to anticipated disagreement, and when the set of anticipated disagreements is sufficiently rich, this immunity causes the optimal contract to give the financier debt. In contrast, the financier’s valuations of other contracts, including equity, decline as anticipated disagreement becomes more severe. This suggests a channel through which an increase in the severity of anticipated disagreement increases the equity premium and the debt-to-equity ratio.

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