A Theory of Debt and Equity, Diversity of Securities and Manager-Shareholder Congruence

A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence
Author(s): Mathias Dewatripont and Jean Tirole

Source: The Quarterly Journal of Economics, Vol. 109, No. 4 (Nov., 1994), pp. 1027-1054
Published by: Oxford University Press
Stable URL: https://www.jstor.org/stable/2118355
Accessed: 23-01-2020 16:08 UTC
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide
range of content in a trusted digital archive. We use information technology and tools to increase productivity and
facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
https://about.jstor.org/terms
Oxford University Press is collaborating with JSTOR to digitize, preserve and extend access
to The Quarterly Journal of Economics
This content downloaded from 152.3.43.49 on Thu, 23 Jan 2020 16:08:09 UTC
All use subject to https://about.jstor.org/terms
A THEORY OF DEBT AND EQUITY:
DIVERSITY OF SECURITIES AND
MANAGER-SHAREHOLDER CONGRUENCE*
MATHIAS DEWATRIPONT AND JEAN TIROLE
This paper shows how the optimal financial structure of a firm complements
incentive schemes to discipline managers, and how the securities' return streams
determine the claim-holders' incentives to intervene in management. The theory
rationalizes (1) the multiplicity of securities, (2) the observed correlation between
return streams and control rights of securities, and (3) the partial congruence
between managerial and equity-holder preferences over policy choices and mone-
tary rewards as well as the low level of interference of equity in management. The
theory also offers new prospects for a reappraisal of the earlier corporate finance
literature.
I. INTRODUCTION
This paper presents a theory of the capital structure of firms.

A rich literature exists on the topic, following the irrelevance result
of Modigliani and Miller. While this literature has generated
numerous insights on the incentive and control aspects of debt and
inside equity, it has not yet simultaneously rationalized the
following stylized facts: (1) the existence of multiple outside
investors owning diverse securities, (2) the specific correlation
between income rights and control rights of these securities (that
is, typically, equity control in good states of nature and debt control
in bad states), and (3) the (partial) congruence between managerial
interests and specific outside interests, namely those of sharehold-
ers. Specifically, why are managers' monetary incentives (bonuses,
stock options) traditionally correlated with the value of equity
instead of the value of debt?' Also, why is there typically some
congruence of desired corporate decisions between management
and shareholders (implying shareholders' relative passivity), when
debt-holders are more prone to constrain management if given the
right to do so?
*We thank Patrick Bolton, Drew Fudenberg, Oliver Hart, John Moore, Lars
Stole, and an anonymous referee for comments, and the "P6le d'Attraction
Interuniversitaire" program of the Belgian Government which has supported this
work under grant 26.
1. That is, why does compensation design meant to maximize total firm value
have managers paid in stocks rather than as a function of total firm value, even
when well-functioning bond markets exist?
? 1994 by the President and Fellows of Harvard College and the Massachusetts Institute of
Technology.
The Quarterly Journal of Economics, November 1994
1028 QUARTERLY JOURNAL OF ECONOMICS
Our theory is the first attempt, to our knowledge, to address

the third fact, and to simultaneously address the other two. The
analysis proceeds in the following five steps.
1. The model emphasizes managerial moral hazard in a world
of incomplete contracts, and in which monetary incentive schemes
based on firm profitability are not sufficient to discipline managers.
Endowing outsiders with control rights is desirable, because they
can take actions managers like (dislike) after good (bad) firm
performance, and that cannot be contracted upon.
2. Because these actions (or the circumstances under which
they are taken) are noncontractible, outsiders in control must be
given incentive schemes to take the appropriate course of action.
Such incentive schemes are the income streams attached to the
securities they own. Our theory thus correlates control rights and
income rights of securities.
3. Typically, the incentive scheme assigned to a controlling
outsider, being designed to induce managerial effort, does not
induce ex post maximization of the value of the firm. This implies
the existence of an additional outsider who is residual claimant (to
"balance the accounts" once the manager and the controlling
outsider have been paid according to their incentive schemes).2
4. Assume that the disciplinary action against managers
reduces the riskiness of the final value of the firm (because it
involves canceling some projects, selling some assets, or even
liquidating the firm). Then, inducing a bias in favor (against) such
a course of action can be obtained through a controlling outsider
holding a security whose payoff is concave (convex) in the final
value of the firm, that is, a "debtlike" ("equitylike") asset.
5. If we restrict attention to standard assets like debt and
equity (which involves no loss of generality in this simple model),
we predict debt-holder control after bad performance and equity-
holder control after good performance. This leads to a partial
congruence between managerial and (passive) equity-holder inter-
ests, and a managerial fear toward (interventionist) creditors.
Our analysis is in the tradition of modern corporate finance
models, which allow for optimal security design. It is closest in
spirit to Aghion and Bolton [1992] who, in an incomplete contract
framework, stress the fact that securities are characterized by both
income rights and control rights, and who allow bankruptcy to lead
2. As in Holmstrom [1982], multi-agent moral hazard calls for the existence of

a "budget breaker."
A THEORY OF DEBT AND EQUITY 1029
to various forms of reorganizations Like us, they also allow

company income to be verifiable, a necessary condition to have a
role for equity.4 But their analysis has no role for multiple outside
investors,5 which comes here through managerial moral hazard.
Another related paper is by Hart and Moore [1990], who focus
on designing investors' incentives to stop or not managers from
getting funds for starting new projects. Their model assumes away
managerial incentive schemes and exogenously limits the set of
available securities. On the other hand, it rationalizes multiple
investors and shows how debt priority structures can trade off
managerial underinvestment (Myers' [1977] debt overhang) and
overinvestment (Jensen's [1986] free cash flow).6 Let us finally
mention two papers that also consider how to design outsiders'
incentives through the capital structure. First, in a model of
unverifiable company income, Berglof and von Thadden [1994]
show how giving control to short-termist investors can be optimal.
Second, Berkovitch and Israel [1992] look at the optimal replace-
ment policy of managers by claim-holders. Assuming that replacing
an existing manager by a new one increases risk, they stress
shareholder interventionism and creditors' passivity, which is the
opposite of our result that is based on the reverse assumption about
risk. Their model does not include verifiable performance variables
upon which control could be contingent. Doing so would lead to the
prediction of shareholder control afterpoor performance in their model.
The paper is organized as follows. Section II sets up the model.
Section III derives the optimal managerial incentive scheme, which
requires a given degree of external involvement. Section IV shows
how such involvement can be implemented through an appropriate
capital structure. This framework allows us to "revisit" the
contributions of the early capital structure models in Section V.
Finally, Section VI concludes with a summary of our main insights,
as well as possible extensions of the analysis.
3. Zender [1991] takes a similar perspective.

4. A number of models assume nonverifiable company income, which prevents
the use of managerial monetary incentives schemes or of equity. Debt is instead a
"hard" claim, giving inspection or liquidation rights to its owners (see Townsend
[1979], Gale and Hellwig [1985], Hart and Moore [1989, 1991], or Bolton and
Scharfstein [1990]).
5. Recent work attempts to deal with this multiplicity. For example, Berglof
[1990] and Aghion, Dewatripont, and Rey [1990] stress the functional complemen-
tarity between debt (option to liquidate) and equity (takeover mechanism), without,
however, explaining the multiplicity of claim-holders. And Dewatripont and Maskin
[1990] and Bolton and Scharfstein [1992] consider models of debt where the
existence of multiple claim-holders influences the probability or conditions of
refinancing for managers. These models have no role for outside equity, however.
6. See also Berkovitch and Kim [1990] on this topic.
II. THE MODEL
The model has two periods, t = 1,2.
Managerial Moral Hazard

In period 1 the firm's manager chooses an unobservable effort
level e E {e, e-} with e < -e. The high effort level is efficient, but costs
the manager K in utility terms, while the low effort level costs 0.
The low and high effort levels can be interpreted as the choice of a
bad or good project. K must then be thought of as the private
benefit derived by the manager from choosing the bad project.
Firm profit is assumed to be verifiable. Its value is rt in period
t E {1,2}. The distribution of rt, t E {1,2}, is determined by e. The
first-period profit is not a sufficient statistic for e. Indeed, we
assume that, at the time at which r1 is realized, investors can
observe a signal u, whose distribution is also determined by e and
which is a sufficient statistic for '72. Ideally, managerial monetary
incentives should thus be contingent on r1 and u. However, we
assume u to be noncontractible, so that managerial compensation
can be only indirectly contingent on u.
Interference in Management
After the effort is chosen and the first-period profit r1 and
signal u are realized, the outsider who is granted control chooses
some action A. As in Grossman and Hart [1986], A is assumed to be
noncontractible.7
The firm's capital structure specifies the control structure,
that is, which claim-holder has the right to choose A for each
realization of r1. The capital structure also determines the profit-
contingent revenue stream of each claim-holder. For each 7r1 is, of
course, of particular interest the revenue stream of the claim-
holder who has been granted residual rights of control.
For simplicity, we concentrate on two possible actions, "inter-
vening" or "stopping" (S), and "acquiescing" or "continuing" (C),
soA E {S,C}. Table I provides some motivation for this assumption.
Stochastic Structure
The stochastic structure of the problem is as follows. First, the
density of 7r1 E [frmin, W1max] is denoted by f (r1) for e = e- and f (r1) for
7. As shown in footnote 16 below, our model admits under some circumstances

a complete contract reinterpretation, in which the information about u and the
relevant actions S and C is not readily available and a contingent delegated monitor
is designated to investigate and choose the action A, and is assigned an incentive
scheme in the form of a return stream.
TABLE I
Economic circumstance Action S
Financial distress (illiquidity) or Liquidate, divest, choose conservative option,

poor performance go on a diet (reorganization, wage conces-
sions, reduction of private benefit)
Lack of innovation (R&D firm) Stop project, reduce its size, or redirect it
Nonperforming loans (bank) Reduce risk taking, liquidate
e = e. Similarly, the density of u E [0,1] is - (u) and g(u) for high

and low efforts, respectively (note that we assume for simplicity
that Tr1 and u, and a fortiori 7r1 and Xr2 are uncorrelated conditional
on e). We assume that both distributions satisfy the monotone
likelihood ratio property (MLRP): f(Tr1)/f(7rr) increasin
,rr and - (u)/g (u) increasing in u. Finally, fori each u, the density
of 'T2 E [r2min, "'] is hc (MT2 I U) for action C and hs (MT2 I U) for action
S. Let HC and Hs denote the corresponding cumulative distribution
functions. All densities are strictly positive on their domains of
definition.
The interpretation of the optimal financial structure in terms
of debt and equity requires a further assumption on the stochastic
structure. Namely, we will assume that for each signal u, action S
is "safer" than action C, which has fatter lower and upper tails.
More precisely, we have Assumption 1.
ASSUMPTION 1 (simple decrease in risk).8 For each u E [0,1], there

exists *2 (u) such that
HS(r2 IU) < HC(r2 I U) for 2 < X2 < *2(u)

and
HS(12 U) > HC(2IU fI r )( 2 < < max
This assumption is meant to reflect the fact that reorganiza-

tion typically involves (at least) partial sales of assets or reduction
of activities, which imply a reduced riskiness in firm value. It says
that the distribution of second-period profit has fatter upper and
lower tails under action C. A decision maker with a return convex
8. See Dionne and Gollier [1992] and Meyer and Ormiston [1989] for analyses
of the implications of simple decreases in risk for individual choice. Two distribu-
tions can be ordered in terms of this criterion even if they do not have the same
mean. Note that a simple increase in risk implies a mean preserving spread if the
two distributions have the same mean.
in IT2 thus prefers action C more often (that is, for a larger set of
signals) than one with a return linear in Xr2, who in turn prefers C
more often than one with a return concave in X2.
Let us finally be more specific concerning Hc and Hs, and make
ASSUMPTION 2.
(a) d[Hs('r2 I U)-Hc(r2 I u)]/du > 0 for all -X2and u

(b) 3 u E [0,1] such that EHc (IT2 Ii) = EHS(Q2 I a).
Assumption 2(a) means that action C is more appealing for
higher signals. Assumption 2(b) implies that, for low u's, action S is
ex post efficient; that is, it maximizes expected second-period profit.
Preferences
Our theory is based on the (tautological) idea that managers do

not like outside interference in their management. In our model,
interference will correspond to action S. In reality, there are
several reasons why managers dislike their projects being inter-
rupted or altered, for instance.9
(1) they are likely to receive higher monetary rewards (bo-

nuses, stock options) if the project they started is pursued
because continuation yields a fatter upper tail for the
distribution of profits;
(2) they enjoy private benefits as long as the project continues.
We will call those two reasons "monetary incentives" and

"private benefit," respectively. Both reasons lead to the same
conclusions about the optimal financial structure and about the
congruence of shareholders' and managerial preferences over the
choice of action. Because the private benefit story abstracts from
the derivation of monetary incentives, it is simpler and will be
treated in subsection III.1 as an illustration. The private benefit
story, however, cannot account for the specific monetary incentives
observed in practice and therefore cannot rationalize the congru-
ence of shareholders' and managerial preferences over return
streams. It is thus important to consider monetary incentives both
to match reality and to assess the assumption of many early capital
structure models (e.g., Jensen and Meckling [1976], Ross [1977],
and Myers and Majluf [1984]) that the manager acts in the interest
of shareholders in their "non-effort" decisions.
9. They may also enjoy a better reputation in the labor market if their decisions
are not reversed.
Monetary Incentives
Subsection III.2 assumes that the manager enjoys no private

benefit and is responsive to monetary incentives. The manager's
utility is U(w) for e = e and U(w) - Kfor e = e, with U (w) = - oo for
w < 0, U(w) = w for w E [O,1], and U(w) = 1 for w> 1. Managerial
utility is thus piecewise linear, with a horizontal segment for w ? 1
and a vertical segment at w = 0. We can thus focus on w E [0,1],
with risk neutrality inside this segment. The manager's reserva-
tion utility is assumed to be equal to 0.
The Appendix makes simple assumptions which, together with
the assumption that action C gives a fatter upper tail for second-
period profits, guarantee that a manager with purely monetary
incentives prefers action C. Roughly, these assumptions are that
the distribution of second-period profits (for a given interference
policy) satisfies the monotone likelihood ratio property with re-
spect to effort, at least for high profits (so, one wants to reward high
second-period profits); and that there is free disposal (managerial
compensation cannot decrease with second-period profit).
Private Benefit
Subsection III. 1 assumes for simplicity that the manager does

not respond to monetary incentives and receives a constant wage
0.10 She receives no private benefit if the project is stopped. If the
project is pursued, the manager receives private benefit B > 0.
Timing
The timing of the model is summarized in Figure I.

At stage (i) the managerial incentive scheme is chosen. The
manager's compensation, w (rr1, '2), is contingent on verifiable f
performance. Securities are also issued. They involve financial
return streams (contingent on 7r1 and 7r2), as well as residual rights
of control (contingent on 7rr) for stage (v) concerning the choice of
action.
Events taking place at stages (ii), (iii), and (vi) are self-
explanatory. Note that the choice of action at stage (v) is, in the
absence of renegotiation, determined by the income stream estab-
lished by the firm at stage (i) for the controlling party. Because this
choice may be inefficient, parties may have an incentive to renegoti-
10. So, in the previous notation, U (w) = - o for w < 0 and U (w) = 0 for
w > 0.
(i (ii) (iii) (iv) (v) (vi)

I I I I I I >
Contracting Choice of e (pi, u) Renegotia- Action A P2 realized,
stage: the by manager realized tion stage taken by income shared
capital struc- controlling according to
hire and mana- party (renegotiated)
gerial incen- contracts
tive scheme
are set up
FIGURE I
Timing of Events
ate, which we can allow at stage (iv) once r1 and u have been
realized.
In fact, our results do not depend on the absence or presence of
renegotiation. To keep the paper short, we will consider only two of
the four polar cases, namely private benefit and no renegotiation,
and monetary benefits and perfect renegotiation. The key property
when renegotiation is allowed is that the manager be (at least
slightly) negatively affected when the controlling outsider has a
preference for action S.
III. MANAGERIAL INCENTIVE SCHEME
In this section we derive the optimal managerial incentive

scheme under two sets of assumptions. First, in subsection III.1 we
illustrate the simple case of pure private benefit with no renegotia-
tion. Then, in subsection III.2 we consider the case of monetary
benefits with perfect renegotiation. These two cases will lead to
similar requirements in terms of optimal external intervention,
thus showing that our assumptions about the nature of managerial
rewards or renegotiation are not crucial for the results.
III. 1. Pure Private Benefit and No Renegotiation
Under the simplifying assumption of managerial nonrespon-

siveness to monetary incentives, the manager's ex post rent is B
when the outsider in control wants to choose action C, and 0 when
he wants to choose action S. The optimal incentive scheme, when
renegotiation is impossible, minimizes ex post inefficiency subject
to inducing the manager to choose high effort. Note that, if the
manager's outside opportunity is zero, her individual rationality
constraint is not binding, so only the incentive constraint is

binding.
This subsection determines the optimal managerial incentive
scheme, that is, the optimal probability x(rrl,u) of choosing action
for each ur1 and u. This incentive scheme corresponds to standard
agency theory, since it is in effect a complete contract. It is only
because of the noncontractibility of actions and of the signal u that
we have to turn to the implementation of x(rrl,u) through the
capital structure. This is done in a second step, in Section IV, which
constitutes the novelty of our analysis. Note that our two-step
approach is vindicated by the fact that the optimal function x
derived in this subsection will be implementable by some financial
structure.
Let us start by defining A(u), the net monetary gain from
continuing given signal u:11
A(u) = f 7r2[hc(r2 I U) - hs(r2 I u)] dir2

= f[HS(72 I U) - HC(72 I a)] dr2 -
From our earlier definition of fi, we have A (a) = 0, A(u) < 0
for u < z and A (u) > 0 for u > ii. We can also define A+ ()-
max (A(u), 0) ? 0, and A-(u) min ((u),O) < 0, soA (A) +(u) +
A- (u). Minimizing ex post inefficiency subject to satisfying the
manager's incentive constraint is thus equivalent to program (1):
min ff [(1 - x(7r1,u))A+(u) - x(7r1,u)A-(u)] f (7rl)k(u) d'rrdu

x(.,.)
subject to
B ff x ('rri,u)[ fwi1)g(u) - f ('rr1)g(u)] d'r1du ? K,
where x ('r1 ,u) is the probability action C is chosen given 7rr and u.
Let us assume that K is small enough so that a solution to program
(1) exists. The derivative of the Lagrangian of this program is
A(u) f ('Trr)g(u) + pB[ f (wrl)g(u) - f ('rrl)g(u)],

where [L is the Lagrange multiplier. Since, by MLRP, f (,rl)/f ('71)
increases in r1 and - (u)Ig (u) increases in u, the solution is of
11. To avoid burdening the notation, we use indefinite integrals whenever they
concern the entire domain of definition of u, rri, or 1r2.
the form,
u < U*(Qrl) X(7rru) = 0
u ? u*(n1r) x(rr1,u) = 1,
where u*(rri) is decreasing in u1.
The incentive scheme can be interpreted as follows. Since u is
positively correlated with effort, one would like to punish the
manager for low u's, by threatening to choose action S. Since 7r1 is
also positively correlated with effort, such threats have to occur
more often for low ur1's: A low ur1 is bad news about effort, so more
external interference is warranted. This fact will imply that when
the contract is incomplete the manager should be punished for low
current profits by giving control of the firm to outsiders who have an
interest in choosing actions which hurt the manager. Section IV
will show how such contingent action choices, described in Figure
II, can be implemented by an adequate capital structure.
1_
min max
FIGURE II
FIGURE II
III.2. Monetary Incentives and Perfect Renegotiation
This subsection, which can be skipped in a first reading, differs

from subsection III. 1 in terms of managerial utility and of renego-
tiation. Instead of private benefits, we assume monetary benefits
U(w) = w for w E [0,1], U(w) = - Xo for w < 0 and U(w) = 1 for
w > 1. Moreover, in this subsection we allow for renegotiation, and
we even assume that it completely eliminates ex post inefficiencies.
We also assume that the manager has no bargaining power in the
renegotiation process, so that her utility is not affected by it. These
assumptions are not crucial for our results. Renegotiation imperfec-
tions would just add some ex post inefficiency, which would have to
be accounted for as in subsection III.1. Moreover, giving some
bargaining power to the manager would preserve the results
provided that she has to make at least some concession to prevent
the controlling party from going against her will.
As in the previous subsection, we can here focus on the optimal
managerial scheme, which will imply an external intervention rule
which we derive in Section IV. Given our assumption of perfect
renegotiation, ex post efficiency will be achieved whatever the
managerial incentive scheme. Allocative efficiency thus simply
means inducing the manager to choose the high effort level.
Maximizing the value of the firm means achieving allocative
efficiency while minimizing the expected rent accruing to the
manager, which represents the agency cost (AC) in this case. Since
we have assumed that the manager has no bargaining power in the
renegotiation, the managerial rent is defined by the incentive
scheme prior to renegotiation. The optimal managerial incentive
scheme now involves the choice of w (-r1,rr2) for each ('r1,'rr2) and of
probability x(rrl,u) that action C is taken in the absence of
renegotiation for each pair ('rrl,u). Minimizing agency costs is no
equivalent to program (1'):
mmi AC = [x(,rlu) hcT2 1 u)
+ (1 - X (Qrl,u))hs(rr2lu)]w(,rr1,rr2) Tf (rr)(u) drr2 dud'rr
subject to
AC ? ff r [xrriu)hc(rr2IU)
+ (1 - x (Qrru))hs(rr2lu)]w(,rr1,rr2) f ('rrl)g(u) drr2 dud'rr+K.
The Appendix shows that, under natural assumptions, the

solution to program (1') is as follows.
(1) For each 'rr, there exist u* (Qrc) and H* (Qrr) such that action
S is chosen (x(rrl,u) = 0) if u < u*(rrl), and action C is
chosen (x(rrl,u) = 1) if u ? u*(rrl); and such that w(rr,,7r2) =
1 if 7r2 ? H* (7rr), and w(7rr,7r2) = 0 otherwise.
(2) u*(Qri) and H* (,rl) are decreasing in m1.
In words, there is interference (action S) if and only if the
first-period profit and the signal lie below a downward sloping
curve similar to that depicted in Figure II. The manager further
receives a bonus (w = 1) if and only if first- and second-period
profits are high enough. The result concerning the wage schedule is
quite natural: the manager is rewarded for a high second-period
profit, and the target level of second-period profit is higher the
lower the first-period profit, which is positively correlated with
effort.
The Appendix obtains this characterization of the wage sched-
ule from the following set of assumptions: (1) the disutility K of
effort is low enough to allow the manager to be rewarded only for
high second-period profits, so that action S is indeed worse for the
manager than action C which has a fatter upper tail (Assumptions
1' and 4); (2) higher second-period profits must be correlated with
higher effort on average, at least for all r2 ? H* ('rrm) (Assumption
3); (3) the manager can throw money away, so that w(.) must be
monotonically increasing in rr2 (Assumption 5).12 The above assump-
tions guarantee a well-behaved wage schedule w(rl,'rr2). Because
the manager receives a profit option (being rewarded in the upper
tail of rr2), action S is an endogenous punishment. This means that
the manager always prefers action C to action S, even when action
S is ex post efficient.
Let us note that, because managerial rewards are contingent
on accounting variables (profits) but not on financial ones, our
model with monetary benefits is formally one of a closely held firm
In a publicly held firm the stock price contains some information
about the signal u received by claim-holders. The managerial
reward then depends both on profits (bonuses) and on the stock
price (stock options). Our theory must be extended slightly in order
12. Assumptions 3 and 5 guarantee the monotonicity of w(.) on the entire

interval [7r2minrF2`]. We make Assumption 5 because very low 7r2'S may be good news
about effort since hc (.) has a fatter lower tail than hs (.), so that low r2's are
positively correlated with action C, and thus with the event u 2 U* (i).
to apply to publicly held firms. For, assume that the stock price at
the end of period 1 perfectly reveals u. The managerial reward then
depends on the first-period profit and the stock price only, and the
manager is unaffected by external interference (which only affects
the period 2 profit); as in Modigliani and Miller, the financial
structure is irrelevant.
There are, however, (at least) three reasons why our theory
applies to publicly held firms as well. First, control rights always
matter when the manager's private benefit is strictly positive as in
subsection III.1. Second, in a situation of repeated moral hazard in
which managers exert a second-period effort as well, the reward
ought to depend on second-period profit even if u is perfectly
revealed by the stock price, which makes the managers sensitive to
external interference in the first period. Third, financial variables
may not perfectly reveal the signal u; for example, stock prices may
be garbled by noise trading or asset bubbles. In such a case, the
financial variables are not sufficient statistics for the second-period
profit, and the managerial reward should again depend on second-
period profit, making managers sensitive to external interfer-
ence.13 For those three reasons, managers are affected by external
interference despite the fact that public trading enlarges the set of
performance measures and thus favors monetary compensation
over noncontractible incentives. Thus, the financial structure still
plays a disciplining role.
IV. OUTSIDERS' INCENTIVE SCHEMES
This section is concerned with finding financial structures that

implement the optimal choice of action by outsiders, namely, in
both cases of Section III, action S when u < u*(Trl) and action C
when u ? u*(Trl), for all Tr,. As stressed earlier, income streams
must be structured so that the outsider with control rights finds it
optimal to implement such choice of action. This requires in turn at
least one additional outside investor, in order to "balance the
accounts," that is, receive residual firm income once the manager
and the outsider in control have been paid.14
13. This reason is less normative than the other one because it takes the stock
market institution as given (see Holmstrom and Tirole [1993] for an analysis of its
usefulness in terms of managerial incentives). An alternative way of justifying
nonfully revealing asset prices is to assume that asset markets are not competitive.
For instance, signal u might be observed by a single outsider (a main bank, say).
14. Our theory does not necessarily imply contingent control rights, because
one could pick a single controlling outsider and adjust his incentive scheme for each
Let us define r1 as the first-period profit level such that u*

(*r) = az. For first-period profit less than fr1, the optimal managerial
incentive scheme thus implies excessive reliance on action S, while
it is the opposite for first-period profit higher than fr1. It is only
when first-period profit equals fr1, that is, with probability zero,
that control is given to an outside investor whose choice of action is
ex post efficient. Giving control to a single investor would thus be
inappropriate, since he would always choose action C if and only if
U ? U.
Let us show that the optimal interference policy derived in
Section III can be implemented by two standard financial instru-
ments, debt and equity. Specifically, call D2 the amount of long-
term debt of the firm, to be serviced at the end of period 2.15
Assume for example, that, for a given level of first-period profit,
control rights belong to a claim-holder owning a proportion a of the
long-term debt of the firm and a proportion a of its equity
(standard debt corresponds to a = 0 and standard equity to a = 0).
For a given signal u, a decision to continue yields the following
payoff for this claim-holder:
aX [fz rr2hc(rr2 1 u) drr2 + D2(1- HC( u))

remax
+ 13 2 ('rr - D2)hc(rr2 1u) dr2.
LD2
Similarly, a decision to take action S yields
mD2 r2hS(1T2 1 u) dT2 + D2(1- Hs(D2

mi22 U))]
[ max
+ 131 72 (,. - D2) hs(rr2l u) dr2.
The net payoff to continuing is thus, after integration by parts,

~ D2
A = aO [Hs(r2 IU) -Hc(r2 I W)] drr2
+ vJ [HS(7r2 I U) - Hc(Tr2 d u)]
value of rrl. This would typically be a very complex incentive sch

realism and without loss of generality, we focus instead in this se
of standard securities and contingent control rights to implement
choice described in Section III. Note also that there is no presum
single controlling outsider with varying return streams would be
tasks, such as monitoring, are taken into account.
15. That is, by accounting convention, D2 includes the amount of unpaid
short-term debt D1 - Tr1 (where the short-term debt is to be defined below) if D1
Tr,. If Tr1 > D1, the surplus Tr1 > D1 is distributed as a dividend in period 1.
The choice of action of an outsider holding proportions a and

A, respectively, of the long-term debt and of the equity of the firm
hinges on two considerations. First, by Assumption 2(a), the net
payoff to continuing is increasing in the signal u, for any given
(a0,1). Since a higher signal favors action C relative to action S.
there exists a cutoff level u(a,AD2) such that the controlling
claim-holder chooses action S for signals below this cutoff, and
action C otherwise. Second, what determines this cutoff level?
Concerning a and A, only the relative proportion of debt and equity
matters, that is, a/1P. For a = PB, the claim-holder in fact maximizes
total firm value, so that his cutoff level is ex post efficient
(u(,aCD2) = a for all a and D2's). Instead, by Assumption 1,
implies a cutoff above iz. Indeed, a debt bias (a > P) m
excessive reliance on S; conversely an equity bias (a > P) e
sively favors action C.
If we further specialize implementation by restricting (aLA) to
(1,0) or (0,1), that is, pure debt orpure equity control, we must set a
level of short-term debt D, = fr1, with debt control when first-
period profit is lower than D, and equity control otherwise,16 as
depicted in Figure III.
Note that, in order to implement u* ('rrl), the long-term debt
level D2 must vary appropriately with first-period profit. Specifi-
cally, for first-period profit higher than D, (equity control), D2 is
determined by
rmaxc
(3) [12 HSrr2 I U*Q(Tr)) - Hc(T2rI u*Q(rrl))] dlr2 = 0.
D2
16. As mentioned in footnote 7, one can give an alternative interpretation to

our incomplete contracting/property right approach to the financial structure in
terms of the more standard complete contracting paradigm. Take, for example, the
assumptions of subsection III. 1 (nonmonetary incentives), and suppose that ex ante
there are n > 2 a priori identical actions A that outsiders can take. Out of these n
actions, (n - 2) turn out to be very low profit actions, while the remaining two yield
the payoff structures associated with what we labeled S and C. The outsiders cannot
tell the n actions apart without incurring monitoring cost M, in which case they
perfectly learn the payoff structure associated with each action. The cost M has to be
incurred after Tr, and u have been realized, because, by assumption, it is only at that
time that one can find out which actions are optimal. This monitoring cost cannot be
saved because the manager will always recommend action C and cannot be
overruled by ignorant outsiders who are too concerned that they might select o
the (n - 2) bad actions. We can otherwise assume that u is either common
knowledge or learned when the monitoring cost M is incurred. The reinterpretation
is a model of double moral hazard (on the manager's and the delegated monitors'
sides). M is a noncontractible disutility. The outsider who, given Tr,, is supposed
act as delegated monitor, is given a return stream equal to that of the outsider in
control (debt or equity) as in this section. Provided that M is small enough and S has
positive probability in the optimal scheme even for rrT'm (so that the outsiders do not
want to rubber-stamp the manager's recommendation of picking C), the delegated
monitor/outsider in control monitors and picks the decision according to the
decision rule u* (ri).
1_
incentive efficient partition

(action C iff uu*(m1))
expost efficient partition

(action C iff u~u)
determ d byexcessive
passivity
0
and n debt control equity control max
FIGURE LIII
When first-period profit is lower than Dr (debt co

determined by
(4) [n HS(rr2 I U *QI71)) - HcQZTr2 I u*QETil))] dlT2
The dependence of long-term debt on first-period

fact a direct consequence of Assumptions 1 and 2(a): f
and equity control, that is, in equations (3) and (4), lo
must rise with first-period profit. In the region of d
higher long-term debt raises the debt-holders' gain f
ing: a higher level of long-term debt raises the depen
value on the upper tail of the distribution of second-
In the region of equity control, higher long-term deb
the equity-holders' gain to continuing, as they put m
profits in the upper tail. In terms of managerial ince
paribus, long-term debt softens the outsider in cont
managerial interests, while short-term debt, by increasing the
probability of debt-holder control, threatens managerial interests.

Note also that we can think of D2 as the maximum amount of debt
that the manager can issue for each lrr (as specified in stage (i)
initially), where this ceiling grows with current performance for a
given controlling outsider. In order to soften outsiders, the man-
ager will always want to have as much long-term debt as is allowed.
Within each of the two regions of equity control (u* < a) and
debt control (u* > a), long-term debt thus increases with first-
period profit: the higher the current firm profit, the more it is
allowed to borrow. While the prediction that the manager is
allowed to (and will) borrow more, the better the performance,
seems natural, there is an unfortunate discontinuity at a, where D2
jumps from rr~max to min when controls switches from debt to equity
(see Figure IV). Indeed, under equity control, when u* (rri) tends to
a from below, D2 tends to Tr min because a zero level of risky
outstanding debt is required to induce shareholders to maximize
total firm value. Similarly, under debt control, when u* (Qir) tends
to a from above, D2 tends to irrm', in order to make debt-holders full
residual claimants. This discontinuity is in fact a logical conse-
quence of any control mechanism that abruptly transfers control
from one category of claim-holders to another. The continuity of
the managerial incentive scheme implies that debt-holders and
equity-holders should behave almost identically around a despite
their very conflicting objectives. Therefore, restoring continuity of
decision-making at signal a requires a discontinuous change in D2.
There are of course similar but more realistic ways of imple-
menting u* (.), in particular with long-term debt levels monotoni-
cally increasing in current performance over the full range. For
example, one can allow equity-holders to retain control even after
poor performance provided that they recapitalize the firm.
Specifically, return to Figure IV, and pick a first-period profit
level Tr1 higher than *1. This profit level thus belongs to the equity
control region. Equation (3) defines an associated debt level D2
which induces equity-holders to choose action C if and only if u >
u* (7'r1). For fr1 close enough to *i, D2 is lower than all debt levels
associated with debt control, that is, all debt levels defined by
equation (4) for rr1 < fr1. Consequently, since the bias for action S
is higher the lower the long-term debt level, if debt-holders were
given control with a leverage D2, they would be quite conservative:
namely, there would exist u2 greater than u* (lrrmin) such that they
would choose action S if and only if u ? i, as shown in Figure V.
irmax
2
D2~~~D
l7rmnx L
D2~~~~~D
2 m in max
FIGURE IV
Implementation now works as follows. First, for mrl greater

than fr1, equity-holders retain control unconditionally, with long-
term debt D2 defined as before by equation (3). Second, for mr less
than Tr1, control shifts to debt-holders, with long-term debt D2,
unless equity-holders recapitalize the firm by injecting an amount
of money I(1rr) conditional on first-period profits. This amount
I(7rr) is chosen so as to induce them to recapitalize the firm
whenever u < u* (Qrr) if they fear debt-holders would choose action
S. Specifically, I(1rr) is defined by
max
(5) * iT2 [r2-D2] hs(r2 I u*(7rl))diT2

D2
= f2 [P2-D2 + I(ml)] hc(r21 u*(,rl)) drr2 - I(rr).

D2-I(rrl)
It is easy to show that the shareholders' net gain of avoiding

action S through the injection of I (,l) grows with the unverifiable
1.
debtholders'decision rule
with leverage t2
FIGURE V
signal u 17 Moreover, it is also clear that I~rr1) is decreasing in qrr1:

for a lower qrr1, equation (5) must be satisfied for a higher
unverifiable signal, which can be achieved by a higher I~rr1).
Raising I~rri) raises the net cost of recapitalization, because
equity-holders' final gross payoff does not rise by I~rr1), but only by
17. The net gain of recapitalization for a given u is
T2[1-HC(vr2Iu)I dsr2 Irri)-Cf [1-Hs~rr2Iu)] d'r2

f r [HS(r2 u) U)Hc~rr2Iu)I drr2- fI Hc~rr2I1u) dr2,
which grows with u since (H8 Hc) grows with u and HC decreases with u.
a fraction of that payoff. Indeed, part (or all) of I(rl) will benefit
debt-holders in the end.
Consequently, for first-period profits lower than f'r, three
cases can arise, depending on the value of u:
(a) u < u*(rri): shareholders do not find it worthwhile to
recapitalize, and control goes to debt-holders, who choose
action S.
(b) u*(rri) < u < a: shareholders do recapitalize and keep
control, in order to avoid action S.
(c) u < u: shareholders do not recapitalize, because they are
happy to let debt-holders choose action C.
The above mechanism thus also implements the optimal
managerial incentive scheme. Moreover, it does so without any
discontinuity in long-term debt (which is constant for first-period
profit below f'r, then rising with first-period profit) or in the level of
recapitalization (which converges to zero for first-period profit
converging to fr, from below).
Note that, while there are several ways to exactly implement
u*(0) through realistic financial structures, the prediction of the
model that is really robust concerns the negative dependence of u*
on 7ri, which implies that low first-period profits are followed by
excessive toughness by outsiders (u* > a) and high first-period
profits are followed by excessive passivity (u* < a). Moreover,
excessive toughness is associated with a debt bias in control by
outsiders, while excessive passivity is associated with an equity
bias.'8 This model thus generates a partial congruence between
managerial interests and equity interests, with a stronger opposi-
tion between managers and debt-holders.
VI. USING CONGRUENCE TO REVISIT EARLY CAPITAL

STRUCTURE MODELS
Many key contributions of the early literature on corporate

finance have assumed that managers maximize shareholders'
welfare when they make non-effort decisions.'9 Those contribu-
18. Recall that a debt bias (respectively, equity bias) means that the optimal
degree of interference cannot be implemented by an outsider whose payoff is a linear
or convex (respectively, concave) function of profits.
19. Contributions making this assumption include Jensen and Meckling's
[1976] agency model of debt and outside equity, Ross' [1977] model of signaling
through debt, Myers and Majluf's [1984] analysis of share issues, Jensen's [1986]
"free cash flow" argument, and the large literature motivating dividends by
signaling concerns (surveyed in Allen [1991]).
tions have often been criticized on the ground that there is no

reason in the models for such an assumption. We view this
methodological critique as well taken, but we wish to warn the
reader against a hasty dismissal of these contributions. For, if
optimal security design somewhat aligns managers' and sharehold-
ers' monetary preferences, managers will act in the interest of
shareholders, at least for decisions that involve low stakes in terms
of effort, perks, or ego. Our theory thus permits us to revisit and
reconsider these early contributions, as we now show through a
simple extension of our model.
To illustrate this, consider the monetary benefit model with
timing summarized in Figure I, and add a second, optional project
together with a stage at which the manager learns private informa-
tion about the profitability of this second project (between stages (i)
and (ii), after the contract is signed). The second project may be
"good" or "bad." The profits of the two projects cannot be
disentangled. So, depending on whether there is interference or not
in the primary project in period 1, the cumulative distribution of W2
is Hs or Hc if the second project is not undertaken, Ms or Mc if the
second project is undertaken and good, and Ns or Nc if the second
project is undertaken and bad. The rest of the model is unchanged.
The revelation principle implies that the manager's reward
and the decision of whether to undertake the second project depend
on the manager's announcement of the project type. The analysis,
which we only sketch, follows the lines of subsection III.2, except
that incentive compatibility now requires also that the manager
truly reveal the nature of the second project. The optimal contract
may lead to never undertaking the second project (in which case
the solution is that of subsection III.2) or to always undertake it, or
else to undertake it only when it is good. The first two policies can
be labeled as "pooling policies" and the third one, on which we
focus, as a "separating policy."
Assume that the manager likes to undertake the second
project whether good or bad. The idea is, in the context of the model
of subsection III.2, that the second project increases the riskiness
of profits, thus inflating the upper tail of the distribution and
increasing managerial rent. The logic of the model is thus similar
to that of the "free cash flow problem": Jensen [1986] points out
that managers, when left unconstrained by claim-holders in their
use of the firm's cash flow, may engage in negative net present
value projects. Jensen then argues against retained earnings and
for the use of debt to constrain managers.
Here, much mileage can be obtained by looking at a single

incentive-compatibility constraint. To obtain separation, when
facing a bad project, the manager must prefer the strategy (no
second project, e-) to the strategy (bad project, -e). Because even a
bad second project yields a fatter upper tail than no project, this
incentive-compatibility constraint cannot be met if the financial
structure does not vary with project choice. What is needed to
guarantee incentive compatibility is a tougher financial structure
(more short-term debt, say) when the project is undertaken, when-
ever it yields a higher monetary reward scheme for the manager.20
Our conclusion is thus similar to Ross's [1977] model of
signaling through debt: if the second project gives the manager
higher monetary returns, ceteris paribus, financing it also implies
more debtlike control than when it is not undertaken. Further-
more, Ross's prediction of positive correlation between firm value
and leverage here takes the form of a positive correlation between
firm value and debtlike control (which both increase when the
project is undertaken).
This simple extension thus shows how our model generates
the same effects as earlier contributions which exogenously as-
sumed that managers were biased in favor of shareholders instead
of maximizing the value of the firm. One advantage of our
approach, however, is that it can explain to what extent managers
should be allowed to influence the capital structure, which is
supposed to control them. Here, for example, it is through asymmet-
ric information that the manager gains some discretion, although
not complete freedom, over capital structure choices.
20. For notational simplicity, assume that all profits accrue only in period 2.
Consequently, we have a single cutoff level u* instead of a function u*(Qri).
Mathematically, let "n" and "p," respectively, index "no project" and "project
undertaken." We assume that u contains no information about the quality of the
second project. Thus, in a separating policy' u* and 7rip denote the cutoff signal and
second-period profit when the project is undertaken and thus perceived by outsiders
as being good (while it can be bad out of equilibrium). Similar notation applies when
the project is not undertaken. The incentive constraint mentioned above is
jf(u)[ 1-Hs(rrT* Iu)] du + f -(u)[1 Hc(r*nIu)] du
u fpg(u)[1-Ns(r*2pIu)] du + fJg(u)[1-NC(Q*2p lu)] du.
If, at least for high profits, Ns < Hs and NC < HC (fatter upper tail if the project is
undertaken), this constraint can be satisfied only by having a tougher financial
structure, that is u* < up*, for a given monetary reward scheme, (7rn = sap), when
the project is undertaken.
VI. SUMMARY AND EXTENSIONS
Our analysis has generated a number of general insights.

First, with noncontractible actions, the capital structure of the
firm is a disciplining device for managers, as well as an incentive
scheme for outsiders. An effective external interference in the firm
requires a specific correlation between control rights and income
streams of financial securities. Second, setting up appropriate
incentives for managers and outsiders necessitates multiple securi-
ties, to get around a "moral hazard in teams" problem. Third,
proper managerial incentives require outsiders to go against the
managers' will only when it is likely that they have engaged in
suboptimal courses of action. Poor performance is thus followed by
a high probability of external interference, while good -performance
is rewarded by a low probability of external interference.
When, as is typically the case, external interference reduces
riskiness of firm value, for instance through partial sales of assets
or reduction in activities, debtlike control generates more external
interference than equitylike control. Debt-holders are called to
take control in bad times to act as a "tough principal." Sharehold-
ers are in control in good times, and thus act as a "soft principal."
The cost of debt is then excessive interference, while the cost of
equity is excessive passivity. In our model, although managerial
interests are not perfectly aligned with any of the outsiders',
managerial and equity interests are more congruent than those of
managers and debt-holders. Our model thus not only rationalizes
both debt and outside equity, but also endogenizes the fact that
equity is a "soft" claim and debt a "hard" claim. And it rationalizes
the widespread practice of rewarding management in stocks and
not in bonds, as well as the casual observation that managers tend
to particularly dislike debt-holders' involvement. It thus allows us
to revisit early capital structure models, which exogenously postu-
late a partial congruence between managers' and shareholders'
incentives.
Finally, the model can be extended in several interesting
directions.21 First, assuming that outside claim-holders might care
for private benefits on top of financial return streams could
naturally lead to a theory of takeovers. For example, one could
21. See our working paper [1992] for more details on these extensions, and our
book [1993] for a banking interpretation.
introduce a probability that equity-holders collude with managers

because they share their private benefits. This could lead to
excessive passivity and undermine managerial effort. By appropri-
ately defining implicit control rights and return streams of poten-
tial raiders, the corporate charter and capital structure could
prevent excessive passivity through the threat of takeover by an
outside investor who only values income streams. On the other
hand, if this outside investor derives private benefits from a
reputation for being tough, managers may be subjected to excessive
interference, which would introduce a cost of takeovers in the form
of breach of trust a la Shleifer and Summers [1988].
A second extension concerns the theory of the firm. Consider a
merger of two companies designed to improve coordination. If
control is indivisible, the controlling party may not be able to
commit to selectively intervene and generate the benefits but not
the costs of intervention. Specifically, a division of the newly
formed conglomerate that obtains a low profit may prevent the
firm from reimbursing its short-term debt, and thus let the
conglomerate's debt-holders gain control, even if the performance
of the other division is fair. But then, the better performing
division, which under nonintegration could benefit from share-
holder passivity, is under integration subject to debt-holder inter-
ference with the other division at fault. This problem arises
precisely because the various investors have objectives that differ
from ex post value maximization.
APPENDIX
In this Appendix we detail the assumptions necessary to yield

the results of subsection III.2, as well as the construction of the
solution to the optimization problem (1').
The first-order conditions of program (1') (calling the Lagran-
gian L and the Lagrange multiplier pu) are
AL_
aX(r1,U) = [ f(r)(u)( - 1) - f (Qrl)g(u)Fi]
< 0 if x( rlu) = 0
= E(0,1)
> 0 =1,
where AU(,r1,u) f [hC(r2lu) - hs (Q2Iu)]

manager's willingness to pay for nonintervention, and
AL 1 _
dw~rr1,r2) f go[ f (rl)g(u)(i -
+ (1 - x(rri,u))hS(rr21u)] du < 0 if w(rr1,yr2) = 0
=0 E(0,1)
?0 =1.
Let us now consider the candidate solution Ix(.,.), w(.,.)} where

both x(.,.) and w(.,.) belong to {0,11 for all u, r1 and 2, where action
S is picked iffu < u* (Ql) and where w (Qrr,'2) = 1 iffM2 2 H*2 ('l)
(because program (1') is linear, it suffices to exhibit a solution to its
first-order conditions to obtain a global optimum). In such a case,
we have
A U(rl,u) = Hs(H*2rl) I u) - HC(H*2(,M) I u).

Let us refine Assumption 1 of Section II. Let *'2 denote the
minimum second-period income level such that Hs(r2 I U) 2
Hc('2 I U)for all u and all h2 2 IT2
ASSUMPTION 1'. 2mm <I*2 <m2.IT
Whenever H* (,V1) > A*2, we thus have A U (Qrr,u) > 0, so

the first-order condition on x(.,.) implies that22
(A1) ~~~f (ri)g(u*Qri)) _ i?

(Al) 9f Qrr)g(u*(rr)) - -1
Since f (,ml)/ f (,r1) grows with iT1 and - (u)Ig(u) grows w
(Al) implies that u* (r1) is decreasing in ml. Together w
first-order condition on w(.,.), (Al) implies for our candidate
solution
(A2) g(u *((l))
hs(H (rr)i u)I(u) du + f() hc(H*(Qrl) I u)k(u) du
fUgo~~l) hS(HQ(rl) I u)g(u) du + hc(H*(Qrl) I u)g(u) du
22. In order to simplify the analysis, we assume that lim, ,o g(u)Ig(u) = 0

and lim,,i k (u)Ig (u) = + ox, which guarantees interiorsolutionsforu* (1T)forall Tr,.
Let us now consider how HI* (Qri) varies with r

defined by (Al) and (A2). First, let us check that u
defined for each H*Irl) in (A2). The left-hand sid
LHS) grows with u*(,rrl) by assumption. Concernin
side of (A2) (call it RHS, and call RHSdenom the denominator of
RHS), we have
du*Qrri) = RHSdenom [hS(HI*2(rl) I U * (1)) -hc(H*2(rl) I U*(Qr1))]

x [g(u*(rrl)) - g(u*(Qrl))RHS].
The last term in this expression implies that d RHS/du*(Qr,) is

equal to zero when equation (A2) is satisfied, which can thus
happen at most once since d LHS/du*(Qrl) > 0. On the other h
since - (u*Q(ri))/- (u*Q(ri)) grows with u*Qrl), it is easy to ver
that, at u*(rrl) = 0, LHS < RHS, and, at u*(rrl) = 1, LHS > RHS
(intuitively, the numerator and denominator of RHS are weighted
averages of the - (u)'s and g(u)'s, respectively, with identical
weights). By continuity of both sides, u*(rrl) is thus uniquely
defined for each HI* (,l).
To see how H*Irri) varies with r1 we must consider the
dependence of RHS on HI* (,rl). Note that RHS is nothing but the
ratio of the densities of HI* (Qri) for efforts e and e.
ASSUMPTION 3 (monotone likelihood ratio). RHS is increasing in

HI* (r1) for all HI* (,rl) 2 r2*
Let us now choose HI* (,rmm) = fr2. Given (Al) and (A2) and
under Assumption 3, a cut in l1 raises u*(Qrr) as well as HI* ('l).
(Al) and (A2) then define Iu*Q0rr), HI* (,rl)} such that all HI* (rrl)'s
exceed fr2, that is, the simplification leading to (Al) is justified for
all of them. Our next assumption says that the potential solution
described above is feasible.
ASSUMPTION 4 (K not too large). The solution defined by (Al), (A2),

and HI* (,rmm') = f2 satisfies the incentive constraint.
If, at the above solution, the incentive constraint is not

binding, one can raise HI* (,rmm) above fr2, keeping (Al) and (A2)
satisfied. By continuity, one will reach a point where the incentive
constraint will become binding, since, for lI*2(Qrmlax) -->ax, it
becomes violated.
When H* (rmax) is raised, everything remains well behaved,
because all the u* (rrl)'s increase, and so do all I*) (Qrr)'s, so that all
properties are preserved. If this is the global optimum, we are thus

done. To make sure it is, let us introduce a final assumption.
ASSUMPTION 5 (money can be burnt). w(rrl,'r2) must be (weakly)

increasing in M2*
The reason we need Assumption 5 comes from the first-order

condition with respect to w(.,.). From Assumption 3 we know that
equation (A2) has a unique solution in HI* (,l) for each u* ('rl) on
fr2,'rr2ax]. However, it may have a second solution, belonging to
[P2 9ifT2], because Hc has a fatter lower tail than Hs. In fact, if
hc (Q2 I u)Ihs('r2 I u) becomes negligible for all u when 2 2min we
have this second solution, because, then, LHS is lower than RHS at
H2 (a) = 2 Intuitively, it then becomes profitable to reward the
manager for low 'r2's, because these are correlated with action C,
not S (which makes high Mr2's, but also very low Mr2's, unlikely), and
thus with high effort. However, under Assumption 5, it is not
optimal to reward very low 'r2's, because one must then also reward
the manager for all the 'r2's up to HI*2 (,rl), most of which are
correlated with action S. And the probability mass up to HI* (,a) is
at least as big for action S as for action C. Incentive compatibility is
thus not improved by rewarding very low Mr2's.23
ECARE (UNIVERSITT LIBRE DE BRUXELLES), CEPR, AND CORE

IDEI, CERAS, AND THE MASSACHUSETTS INSTITUTE OF TECHNOLOGY
REFERENCES
Aghion, P., and P. Bolton, "An Incomplete Contracts Approach to Financial

Contracting," Review of Economic Studies, LIX (1992), 473-94.
Aghion, P., M. Dewatripont, and P. Rey, "Optimal Incentive Schemes and the
Coexistence of Debt and Equity," mimeo, 1990.
Allen, F., "Notes on Dividends and the Capital Structure," mimeo, 1991.
Berglof, E., "Corporate Control and Capital Structure: Essays on Property Rights
and Financial Contracts," Ph.D. thesis, Stockholm School of Economics, 1990.
Berglof, E., and E. L. von Thadden, "Short-Term versus Long-Term Interests:
Capital Structure with Multiple Investors," Quarterly Journal of Economics,
CIX (1994), 1055-84.
Berkovitch, E., and R. Israel, "The Design of Internal Control and Capital
Structure," mimeo, 1992.
Berkovitch, E., and E. H. Kim, "Financial Contracting and Leverage Induced Over-
and Under-Investment Incentives," Journal of Finance, XLV (1990), 765-94.
Bolton, P., and D. Scharfstein, "A Theory of Predation Based on Agency Problems
in Financial Contracting," American Economic Review, LXXX (1990), 93-106.
Bolton, P., and D. Scharfstein, "Optimal Debt Structure with Multiple Creditors,"
mimeo, 1992.
23. Note that the first-order condition with respect to w(.,.) is thus valid on
[*2,7r"], but not on [r'2min, *2]: this condition is necessarily not satisfied, an
thus ignore positive wages on this interval thanks to Assumption 5.
Dewatripont, M., and E. Maskin, "Credit and Efficiency in Centralized and

Decentralized Economies," Harvard Institute of Economic Research, working
paper No. 1512, 1990.
Dewatripont, M., and J. Tirole, "A Theory of Debt and Equity: Diversity of
Securities and Manager-Shareholder Congruence," mimeo, 1992.
Dewatripont, M., and J. Tirole, La Reglementation Prudentielle des Banques
(Lausanne, Switzerland: Payot, 1993); English version: The Prudential Regula-
tion of Banks (Cambridge, MA: MIT Press, forthcoming).
Dionne, G., and C. Gollier, "Comparative Statics under Multiple Sources of Risk
with Applications to Insurance Demand," Geneva Papers on Risk and Insur-
ance Theory, XVII (1992), 21-33.
Gale, D., and M. Hellwig, "Incentive Compatible Debt Contracts: The One-Period
Problem," Review of Economic Studies, LII (1985), 647-63.
Grossman, S., and 0. Hart, "The Costs and Benefits of Ownership: A Theory of
Vertical and Lateral Integration," Journal of Political Economy, XCIV (1986),
691-719.
Hart, O., and J. Moore, "Default and Renegotiation: A Dynamic Model of Debt,"
Harvard Business School working paper No. 89-069, 1989.
Hart, O., and J. Moore, "A Theory of Corporate Financial Structure Based on the
Seniority of Claims," MIT, Department of Economics working paper No. 560,
1990.
Hart, O., and J. Moore, "A Theory of Debt Based on the Inalienability of Human
Capital," Quarterly Journal of Economics, CIX (1994), 841-79.
Holmstrom, B., "Moral Hazard in Teams," Bell Journal of Economics, XIII (1982),
324-40.
Holmstrom, B., and J. Tirole, "Market Liquidity and Performance Monitoring,"
Journal of Political Economy, CI (1993), 678-709.
Jensen, M., "Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,"
American Economic Review, LXXVI (1986), 323-29.
Jensen, M., and W. Meckling, "Theory of the Firm: Managerial Behavior, Agency
Costs, and Capital Structure," Journal of Financial Economics, III (1976),
305-60.
Meyer, T., and M. B. Ormiston, "Deterministic Transformations of Random
Variables and the Comparative Statics of Risk," Journal of Risk and Uncer-
tainty, II (1989), 179-88.
Myers, S., "Determinants of Corporate Borrowing," Journal of Financial Econom-
ics, V (1977), 147-75.
Myers, S., and N. Majluf, "Corporate Financing and Investment Decisions When
Firms Have Information That Investors Do Not Have," Journal of Financial
Economics, XIII (1984), 187-221.
Ross, S., "The Determination of Financial Structure: The Incentive Signalling
Approach," Bell Journal of Economics, VIII (1977), 23-40.
Shleifer, A., and L. Summers, "Breach of Trust in Hostile Takeovers," in Corporate
Takeovers: Causes and Consequences, A. Auerbach, ed. (Chicago, IL: Univer-
sity of Chicago Press, 1988).
Townsend, R., "Optimal Contracts and Competitive Markets with Costly State
Verification," Journal of Economic Theory, XXI (1979), 265-93.
Zender, J. F., "Optimal Financial Instruments," Journal of Finance, XLVI (1991),
1645-63.

A Theory of Debt and Equity, Diversity of Securities and Manager-Shareholder Congruence

Загружено:

Сведения о документе

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

A Theory of Debt and Equity, Diversity of Securities and Manager-Shareholder Congruence

Загружено:

Авторское право:

Доступные форматы

A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence

Author(s): Mathias Dewatripont and Jean Tirole

MATHIAS DEWATRIPONT AND JEAN TIROLE

This paper presents a theory of the capital structure of firms.

Our theory is the first attempt, to our knowledge, to address

2. As in Holmstrom [1982], multi-agent moral hazard calls for the existence of

to various forms of reorganizations Like us, they also allow

3. Zender [1991] takes a similar perspective.

II. THE MODEL

The model has two periods, t = 1,2.

Managerial Moral Hazard

7. As shown in footnote 16 below, our model admits under some circumstances

Economic circumstance Action S

Financial distress (illiquidity) or Liquidate, divest, choose conservative option,

e = e. Similarly, the density of u E [0,1] is - (u) and g(u) for high

ASSUMPTION 1 (simple decrease in risk).8 For each u E [0,1], there

HS(r2 IU) < HC(r2 I U) for 2 < X2 < *2(u)

HS(12 U) > HC(2IU fI r )( 2 < < max

This assumption is meant to reflect the fact that reorganiza-

(a) d[Hs('r2 I U)-Hc(r2 I u)]/du > 0 for all -X2and u

Our theory is based on the (tautological) idea that managers do

(1) they are likely to receive higher monetary rewards (bo-

We will call those two reasons "monetary incentives" and

Subsection III.2 assumes that the manager enjoys no private

Subsection III. 1 assumes for simplicity that the manager does

The timing of the model is summarized in Figure I.

(i (ii) (iii) (iv) (v) (vi)

stage: the by manager realized tion stage taken by income shared

capital struc- controlling according to

hire and mana- party (renegotiated)

gerial incen- contracts

III. MANAGERIAL INCENTIVE SCHEME

In this section we derive the optimal managerial incentive

III. 1. Pure Private Benefit and No Renegotiation

Under the simplifying assumption of managerial nonrespon-

constraint is not binding, so only the incentive constraint is

A(u) = f 7r2[hc(r2 I U) - hs(r2 I u)] dir2

min ff [(1 - x(7r1,u))A+(u) - x(7r1,u)A-(u)] f (7rl)k(u) d'rrdu

B ff x ('rri,u)[ fwi1)g(u) - f ('rr1)g(u)] d'r1du ? K,

A(u) f ('Trr)g(u) + pB[ f (wrl)g(u) - f ('rrl)g(u)],

u < U*(Qrl) X(7rru) = 0

III.2. Monetary Incentives and Perfect Renegotiation

This subsection, which can be skipped in a first reading, differs

mmi AC = [x(,rlu) hcT2 1 u)

+ (1 - X (Qrl,u))hs(rr2lu)]w(,rr1,rr2) Tf (rr)(u) drr2 dud'rr

The Appendix shows that, under natural assumptions, the

12. Assumptions 3 and 5 guarantee the monotonicity of w(.) on the entire

IV. OUTSIDERS' INCENTIVE SCHEMES

This section is concerned with finding financial structures that

Let us define r1 as the first-period profit level such that u*

aX [fz rr2hc(rr2 1 u) drr2 + D2(1- HC( u))

Similarly, a decision to take action S yields

mD2 r2hS(1T2 1 u) dT2 + D2(1- Hs(D2

The net payoff to continuing is thus, after integration by parts,

+ vJ [HS(7r2 I U) - Hc(Tr2 d u)]

value of rrl. This would typically be a very complex incentive sch

The choice of action of an outsider holding proportions a and

16. As mentioned in footnote 7, one can give an alternative interpretation to

incentive efficient partition

expost efficient partition

When first-period profit is lower than Dr (debt co

(4) [n HS(rr2 I U *QI71)) - HcQZTr2 I u*QETil))] dlT2

The dependence of long-term debt on first-period

probability of debt-holder control, threatens managerial interests.

(4) [n HS(rr2 I U QI71)) - HcQZTr2 I uQETil))] dlT2

u fpg(u)[1-Ns(r2pIu)] du + fJg(u)[1-NC(Q2p lu)] du.

A U(rl,u) = Hs(H2rl) I u) - HC(H2(,M) I u).

duQrri) = RHSdenom [hS(HI2(rl) I U * (1)) -hc(H2(rl) I U(Qr1))]