The Optimality of Debt Versus Outside Equity
Posted: 11 Jul 1995
This paper demonstrates that in contrast with previous results in the security design literature, nonverifiability of cash flows and managerial ability to divert cash flows as private benefits is compatible with outside equity financing. The only outside equity that is compatible with nonverifiability of cash flows and managerial ability to divert cash flows as private benefits is outside equity with unlimited life. The intuition lies in the control rights associated with outside equity: these control rights are designed to mitigate the management-shareholder conflict only when there is no prespecified expiration date on equity. By making the maturity of debt and equity endogenous in an infinite horizon model, we establish that whereas outside equity with unlimited life is an equilibrium contract, infinite-life debt (perpetual bond) is not. We also find that, consistent with empirical evidence, projects with stable cash flows use debt financing and those with volatile cash flows use outside equity. Furthermore, our theory implies that investors practice maturity-matching: investors match the maturity of the optimal debt contract with the life of the physical assets and the maturity of the optimal equity contract with the life of the company's real options.
JEL Classification: G34, L14
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