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Abstract

Existing theories of debt consider a single contractible performance measure ("output''). In reality, other performance signals are available. It may seem that debt is no longer optimal: if the signals are sufficiently positive, the manager should receive a payment even if output is low. This paper shows that debt remains the optimal contract under additional signals -- they only affect the contractual debt repayment, but not the form of the contract. However, some informative signals will not be used in debt contracts. We show how the contractual debt repayment should depend on valuable signals, providing a theory of performance-sensitive debt.

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