CHAPTER 5. DYNAMIC CONTRACTING only if the manager cannot pay the investors as much as they would get by taking away his control of the asset.(Different bargaining stories would lead to somewhat different conclusions here). Thirdly, because the manager cannot commit to pay the investors in the future, the transfer of control may be inefficient 5.1.3 Aghion and Bolton(1992) Another example of incomplete contracts is provided by Aghion and Bolton (1992). Following Jensen(1986), Aghion and Bolton conclude that managers may use free cash How to overinvest in order to capture private benefits. Debt financing is a method that can be used to restrain managers(the need to pay interest restricts cash flow) and to transfer control of the firm in certain states of nature. The essential assumption is that in states where cash Hlow is low so that the manager cannot service the debt, it is optimal to restrain the manager(transfer control), whereas in states where cash How is high and the manager can service the debt, it is optimal to leave control in the hands of the manager 5.2 Renegotiation Renegotiation is typically regarded as a limitation on the ability of parties to write an efficient contract 5.2.1 Stiglitz and Weiss(1983) Credit markets are characterized by incomplete information, which gives rise to problems of adverse selection and moral hazard. Stiglitz and Weiss(1983) have argued that these problems are mitigated if lenders can threaten bor rowers with punishment in the event of default or poor performance. For example, a firm that defaults on a bank loan may be refused credit in the ture. We noted above that the threat of termination may improve incentives for making an effort In analyzing the optimal use of threats, it is assumed that the lender can commit itself to a particular se of action in advance. Without commit- ment, past default should be regarded as a sunk cost4 CHAPTER 5. DYNAMIC CONTRACTING only if the manager cannot pay the investors as much as they would get by taking away his control of the asset. (Different bargaining stories would lead to somewhat different conclusions here). Thirdly, because the manager cannot commit to pay the investors in the future, the transfer of control may be inefficient. 5.1.3 Aghion and Bolton (1992) Another example of incomplete contracts is provided by Aghion and Bolton (1992). Following Jensen (1986), Aghion and Bolton conclude that managers may use free cash flow to overinvest in order to capture private benefits. Debt financing is a method that can be used to restrain managers (the need to pay interest restricts cash flow) and to transfer control of the firm in certain states of nature. The essential assumption is that in states where cash flow is low, so that the manager cannot service the debt, it is optimal to restrain the manager (transfer control), whereas in states where cash flow is high and the manager can service the debt, it is optimal to leave control in the hands of the manager. 5.2 Renegotiation Renegotiation is typically regarded as a limitation on the ability of parties to write an efficient contract. 5.2.1 Stiglitz and Weiss (1983) Credit markets are characterized by incomplete information, which gives rise to problems of adverse selection and moral hazard. Stiglitz and Weiss (1983) have argued that these problems are mitigated if lenders can threaten bor￾rowers with punishment in the event of default or poor performance. For example, a firm that defaults on a bank loan may be refused credit in the fu￾ture. We noted above that the threat of termination may improve incentives for making an effort. In analyzing the optimal use of threats, it is assumed that the lender can commit itself to a particular course of action in advance. Without commit￾ment, past default should be regarded as a sunk cost