This paper considers a situation where an entrepreneur borrows funds from a creditor (e.g. a bank) to finance an investment project. The project will on average generate returns in the future, but these returns accrue in the first instance to the entrepreneur and cannot be allocated directly to the creditor. The role of debt is to provide an incentive for the entrepreneur to transfer some of the future receipts to the creditor. The idea is that if the entrepreneur does not pay his debt, the creditor has the right to seize some fraction of the debtor's assets. We analyze the implications of this right for the form of the long-term debt contract and for the efficiency of the debtor-creditor relationship. We pay particular attention to the face that, given that the liquidation value of the assets is typically less than their value to the debtor, the creditor will often choose not to exercise her right to seize the assets, preferring instead to renegotiate her loan. However, in some cases, the inability of the debtor to commit credibly to pay a sufficient portion of the assets' future value to the creditor means that liquidation will occur anyway even though it is inefficient. Thus, among other things, the theory provides and explanation of the social costs of default or bankruptcy.
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