Heterogeneous Beliefs, Moral Hazard, and Capital Structure
Free University Berlin, Department Accounting and Finance
Schmalenbach Business Review, Vol. 55, April 2003
This paper provides a new approach to the theory of capital structure by emphasizing the issue that investors and entrepreneurs may have heterogeneous beliefs on future firms returns. Heterogeneous beliefs are possible even when there is symmetric information but individuals evaluate the same information differently. Although heterogeneous beliefs might be an important issue in real life, corporate finance theory hardly addresses them. When heterogeneous beliefs and moral hazard exist, a debt-equity mix might outperform pure debt or pure equity. I examine a situation in which there is perk consumption (which favors debt) and heterogeneous beliefs on project risk (which favors equity in case of risk neutrality) and heterogeneous beliefs on the project's mean (which favors debt). Optimal contracts tend to be highly nonlinear with heterogeneous beliefs.
Keywords: Behavioral Finance, Corporate Finance, Heterogeneous Beliefs, Moral Hazard
JEL Classification: G31, G24
Date posted: July 16, 2003