Project Risk Choices Under Privately Guaranteed Debt Financing

Although a considerable amount of research has been undertaken on detrimental risk taking by managers, much less studies are devoted to endogenizing risk choices in the context of corporate project financing and in the presence of financial guarantees. A firm's risk appetite increases greatly when it has a guarantee contract on its debt, which creates a conflict of interest between the firm and the guarantee provider. To address this moral hazard issue, we propose an equilibrium model in which the borrowing firm and the guarantee provider pre-commit themselves to conscripted risk levels at the signature of the contract. We show if the borrowing firm and the guarantor pre-commit, the equilibrium risk level is lower than the one the firm will choose unilaterally. When the firm's shareholders have a big equity stake in the new project, for short (long) maturity debts, both parties gain by agreeing on a high (low) risk project. We also find that the optimal risk level of the borrowing firm is entirely driven by its ex-post capital structure