This paper analyzes a dynamic model of debt, focusing on the role of debt in providing incentives for the entrepreneur to transfer future returns to the creditor. The model considers a situation where an entrepreneur borrows funds from a creditor to finance an investment project. The project generates returns in the future, but these returns initially accrue to the entrepreneur and cannot be directly allocated to the creditor. Debt serves as an incentive mechanism to encourage the entrepreneur to transfer some of the future receipts to the creditor. The paper examines the implications of the creditor's right to seize assets in the event of default. It highlights that the creditor may choose not to liquidate the assets, preferring instead to renegotiate the loan. However, in some cases, the inability of the debtor to commit credibly to pay a sufficient portion of the assets' future value to the creditor may lead to liquidation, even though it is inefficient. The theory provides an explanation of the social costs of default or bankruptcy. The paper also discusses the role of debt as a mechanism for releasing funds from a firm, emphasizing the control rights associated with debt rather than its incentive properties. It considers the role of debt in financial structure, where debt is seen as a bonding or signaling device. The paper analyzes the optimal contract between the debtor and creditor, considering the trade-offs between different forms of debt and the efficiency of the debtor-creditor relationship. The model considers a two-period case where the entrepreneur requires initial investment funds to finance a project. The project generates uncertain returns, and the entrepreneur must design a pay-back agreement to persuade the creditor to provide the necessary funds. The paper analyzes the implications of default and renegotiation, considering the effects of different debt levels and the role of the creditor's ability to seize assets. The paper also discusses the social efficiency of debt contracts, highlighting the importance of the creditor's ability to enforce repayment and the role of renegotiation in achieving efficient outcomes. It concludes that the optimal contract will give the debtor control of the assets in as many states of the world as possible, subject to the constraint that the creditor recoups her initial investment. The paper provides a framework for understanding the dynamics of debt, default, and renegotiation in financial contracts.This paper analyzes a dynamic model of debt, focusing on the role of debt in providing incentives for the entrepreneur to transfer future returns to the creditor. The model considers a situation where an entrepreneur borrows funds from a creditor to finance an investment project. The project generates returns in the future, but these returns initially accrue to the entrepreneur and cannot be directly allocated to the creditor. Debt serves as an incentive mechanism to encourage the entrepreneur to transfer some of the future receipts to the creditor. The paper examines the implications of the creditor's right to seize assets in the event of default. It highlights that the creditor may choose not to liquidate the assets, preferring instead to renegotiate the loan. However, in some cases, the inability of the debtor to commit credibly to pay a sufficient portion of the assets' future value to the creditor may lead to liquidation, even though it is inefficient. The theory provides an explanation of the social costs of default or bankruptcy. The paper also discusses the role of debt as a mechanism for releasing funds from a firm, emphasizing the control rights associated with debt rather than its incentive properties. It considers the role of debt in financial structure, where debt is seen as a bonding or signaling device. The paper analyzes the optimal contract between the debtor and creditor, considering the trade-offs between different forms of debt and the efficiency of the debtor-creditor relationship. The model considers a two-period case where the entrepreneur requires initial investment funds to finance a project. The project generates uncertain returns, and the entrepreneur must design a pay-back agreement to persuade the creditor to provide the necessary funds. The paper analyzes the implications of default and renegotiation, considering the effects of different debt levels and the role of the creditor's ability to seize assets. The paper also discusses the social efficiency of debt contracts, highlighting the importance of the creditor's ability to enforce repayment and the role of renegotiation in achieving efficient outcomes. It concludes that the optimal contract will give the debtor control of the assets in as many states of the world as possible, subject to the constraint that the creditor recoups her initial investment. The paper provides a framework for understanding the dynamics of debt, default, and renegotiation in financial contracts.