The Good Cop and the Bad Cop: Complementarities between Debt and Equity in Disciplining Management

30 Pages Posted: 4 Mar 2002

See all articles by Alexander Guembel

Alexander Guembel

Toulouse School of Economics, University of Toulouse Capitole

Lucy White

Centre for Economic Policy Research (CEPR); Boston University - Department of Finance & Economics

Date Written: February 22, 2002

Abstract

In this paper we examine how the quantity of information generated about firm prospects can be improved by splitting a firm's cash flow into a 'safe' claim (debt) and a 'risky' claim (equity). The former, being relatively insensitive to upside risk, provides a commitment to shut down the firm in the absence of good news. This commitment provides the latter a greater incentive to collect information than the aggregate claimant would have. Thus debt and equity are shown to be complementary instruments in firm finance. Moreover, we investigate the role of stock markets in transmitting information from equity to debt holders. This provides a novel argument as to why information contained in stock prices affects the real value of a corporation. It also allows us to make empirical predictions regarding the relation between shareholder dispersion, market liquidity and capital structure.

Keywords: Debt, equity, hard budget constraint, information production

JEL Classification: D82, G3

Suggested Citation

Guembel, Alexander and White, Lucy, The Good Cop and the Bad Cop: Complementarities between Debt and Equity in Disciplining Management (February 22, 2002). AFA 2003 Washington, DC Meetings. Available at SSRN: https://ssrn.com/abstract=301842 or http://dx.doi.org/10.2139/ssrn.301842

Alexander Guembel (Contact Author)

Toulouse School of Economics, University of Toulouse Capitole ( email )

Manufacture des Tabacs
21, allee de Brienne
Toulouse, 31000
France

Lucy White

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

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