The Use of Debt and Equity in Optimal Financial Contracts

Posted: 4 Nov 1999

See all articles by John H. Boyd

John H. Boyd

University of Minnesota - Twin Cities - Carlson School of Management

Bruce D. Smith

University of Texas at Austin (Deceased)

Abstract

We consider risk-neutral firms that must obtain external finance. They have access to two kinds of stochastic investment opportunities. For one, return realizations are costlessly observed by all agents. For the other, return realizations are costlessly observed only by the investing firm. We examine the optimal allocation of investment between the two projects and the optimal contract used to finance it. The optimal contractual outcome can be supported by appropriate (and determinate) quantities of debt and equity issues. Investments in projects with CSV problems are associated loosely with debt. Investments in projects with observable returns are associated with equity.

JEL Classification: G10, G32

Suggested Citation

Boyd, John H. and Smith, Bruce D., The Use of Debt and Equity in Optimal Financial Contracts. Journal of Financial Intermediation, Vol. 8, Iss. 4, Available at SSRN: https://ssrn.com/abstract=191515

John H. Boyd (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-624-1834 (Phone)

Bruce D. Smith

University of Texas at Austin (Deceased)

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