To what extend can optimal contracts and renegotiation designs alleviate equity market failure due to asymmetric information and transactions costs? This paper supplies the following clear-cut answers: (1) Optimal contracts (Dybvig and Zender, 1991) can solve a large class of equity financing problems by upholding the socially optimal Net Present Value (NPV) rule. (2) There exists an inefficient investment trap consisting of an over-investment area and an under-investment area. (3) The size of the investment trap is positively related to the degree of asymmetric information and the scale of the investment. It is also affected by the allocation of bargaining power which in turn can be altered by social/governmental forces. (4) Transactions cost shrinks the over-investment trap but expands the under-investment trap. These results help define the roles of and the boundaries between the government and the market, and offer new explanations on some observed investment patterns both within and across countries.
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