Debt, Equity, and Information

Abstract

Most firms issue financial assets such as debt or equity (e.g. bonds or stock) to outside investors. While these financial assets differ greatly in their characteristics, their diversity has received little attention in the literature. Filling this important gap in the literature, this paper views debt and equity as financial contracts and asks why they are optimal instead of other financial contracts. By endogenizing the bankruptcy process, this paper shows how debt and equity arise as a consequence of an optimal allocation of cash-flow rights and monitoring rights, and how equity leads to dividend signaling.

Keywords: financial contracting, security design, debt and equity, monitoring, information asymmetry, renegotiation and bargaining

JEL Classification: C78, D82, D86, G32, G33, G35