Renegotiation and debt forgiveness:-

When computing the multiplier k (given by equation (3.12)), we have assumed that it is optimal to specify a stake for the borrower large enough that the incentive constraint (ICb) is satisfied. Because condition (3.8) implies that the project has negative NPV in the case of misbehavior, such a specification is clearly optimal when the contract cannot be renegotiated. The purpose of this exercise is to check in a rather mechanical way that the borrower cannot gain by offering a loan agreement in which (ICb) is not satisfied, and which is potentially renegotiated before the borrower chooses her effort. While there is a more direct way to prove this result, some insights

are gleaned from this pedestrian approach. Indeed, the exercise provides conditions under which the lender is willing to forgive debt in order to boost incentives (the analysis will bear some resemblance to that of liquidity shocks in Chapter 5, except that the lender's concession takes the form of debt forgiveness rather than cash infusion).60

(i) Consider a loan agreement specifying investment I and stake Rb

(ii) Interpret the previous condition. In particular, show that it can be obtained directly from the general theory. Hint: consider a fictitious, "fixedinvestment" project with income (?p)RI, investment 0, and cash on hand pLRb.

(iii) Assume for instance that the entrepreneur makes a take-it-or-leave-it offer in the renegotiation (that is, the entrepreneur has the bargaining power). Compute the borrowing capacity when Rb.