Moral Hazard and Adverse Selection: The Question of Financial Structure




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    • Darrough is from Columbia University and Stoughton is from the University of California, Irvine. The second author's research was partially supported by Grant Number 410-83-0786 R-l from the Social Sciences and Humanities Research Council of Canada. This paper was presented at the 1984 meetings of the Western Finance Association in Vancouver and at the 1985 European Finance Association meetings in Bern. We thank Kose John and Frans Tempelaar for their comments at the meetings.


This paper looks at the moral hazard and adverse selection problems confronting an entrepreneur offering securities to an uninformed, but competitive financial market. The adverse selection aspect of the problem is generated by the unobservable entrepreneur's ability to transform effort into value. Moral hazard arises because the investment decision is made subsequent to financing. We consider the joint use of both debt and equity, and characterize the equilibrium relation between capital structure and unobservable attributes. It is shown that: (1) investment and financing are not separable; (2) there is an underinvestment problem for “better” firms; and (3) simultaneous use of both debt and equity can resolve this difficulty. We also establish a connection between expected terminal firm value and debt-promised payment level and between share retention and standard deviation.