We consider the design of optimal dynamic financing for a firm subject to moral hazard problems. With respect to the existing literature we enrich the model by introducing durable capital. The existence of durable capital allows us to analyze the role of firm’s size, separately from age and financial structure. We find that a higher level of capital decreases the probability of liquidation, increases future size and reduces the average return and volatility on the assets of the firm. Although analytical results are not available, we show through simulations that the rate of growth of capital is decreasing with size and that its variability first increases with size and eventually it declines. These results are broadly in agreement with the empirical results on the effects of firm size.
Date Written: December 2018