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It has long been understood that moral hazard arises in debt financing. This paper considers the implications of moral hazard issues when a firm makes a sequence of investments and creditors cannot fully specify and/or investors cannot fully commit to the risk of future investments. Sequential real estate acquisitions are an example of the situation the authors are considering. They show that when lenders are aware of the moral hazard problem and act rationally to price this into their debt contracts, the pricing of this risk can bias investment decisions toward riskier investments.
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