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Optimal Financial Structure: An Incomplete Contracting Model
Author(s) -
Leite Tore
Publication year - 2001
Publication title -
scandinavian journal of economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.725
H-Index - 64
eISSN - 1467-9442
pISSN - 0347-0520
DOI - 10.1111/1467-9442.00267
Subject(s) - debt , cash flow , debt overhang , equity (law) , finance , shareholder , gearing ratio , capital structure , business , economics , profit (economics) , internal debt , control (management) , monetary economics , debt levels and flows , microeconomics , corporate governance , management , political science , law
The financial structures of firms observed in practice typically consist of debt claims of different priority and maturity, and outside equity with unconditional control. A simple model is developed in which this type of complex financial structure arises endogenously as a mechanism to allocate control and cash flow rights among the firm's manager and its investors. While short‐term debt commits the manager to liquidate the firm in low profit states, outside equity with unconditional control allows investors to seize control in states where the manager otherwise would pursue low profit projects with high private benefits of control. Finally, long‐term (junior) debt creates a debt overhang that protects the manager from excessive shareholder involvement. JEL classification : G 32