The Use of Debt in Corporate Finance

Abstract

This chapter summarizes the major theoretical and empirical contributions of the financial economics and law and economics literature on the use of debt in corporate financing. It then derives implications for corporate governance, contract law and practice, and organizational law. Because the borrower-lender relationship is governed primarily by contract, the focus is on ex ante contracting and other private ordering, rather than ex post creditor remedies and the bankruptcy regime. Special attention is paid to covenants in debt contracts, as a means of mitigating borrower agency costs. The recent literature emphasizes the extent to which a firm’s capital structure and governance are interrelated. If firms behave efficiently, decisions about how much and what types of debt to employ amount to predictions about which governance regime will optimize firm value.

Keywords: debt, corporate governance, corporate finance

JEL Classification: K22