Internal Finance versus Bank Debt: The Gains from Establishing a Debt History

This paper considers a two-period model in which a firm needs outside financing in period 2. If a firm establishes a reputation with a bank already in the first period, it may reduce the cost and increase the availability of bank debt in the second period. To establish such a reputation, the firm must induce the bank to monitor in period 1. Bank monitoring effort is non-contractible, so the firm induces the bank to monitor by taking an unsecured bank loan. In period 1 a bank loan may then be preferable to internal finance. This contrasts with a result by Myers and Majluf (1984) where firms always prefer to finance profitable investments internally