Risk-Shifting Incentives and Signalling Through Corporate Capital Structure



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    • New York University and University of Chicago. Earlier versions of this paper have benefitted from the helpful comments of Chris Blake, Yuk-Shee Chan, Gene Fama, Larry Glosten, Rob Heinkel, Max Maksimovic, Merton Miller, Bani Mishra, David Nachman, Roy Radner, Marti Subrahmanyam, Tommy Tan, Joseph Williams and participants in seminars at Buffalo, Baruch, Illinois, Maryland, NYU, Ohio State and the AFA, EFA, and WFA. Financial support in the early stages of the project from a Batterymarch fellowship and later stages from a Salomon Brothers fellowship and an Entrepreneurial Institute Research Grant is acknowledged.


This paper examines optimal corporate financing arrangements under asymmetric information for different patterns of temporal resolution of uncertainty in the underlying technology. An agency problem, a signalling problem and an agency-signalling problem arise as special cases. The associated informational equilibria and the optimal financing arrangements are characterized and compared. In the agency-signalling equilibrium the private information of corporate insiders at the time of financing is signalled through capital structure choices which deviate optimally from agency-cost minimizing financing arrangements, which in turn induce risk-shifting incentives in the investment policy. In the pure signalling case the equilibrium is characterized by direct contractual precommitments to implement investment policies which are riskier than pareto-optimal levels. Empirical implications for debt covenants and the announcement effect of investment policies and leverage increasing transactions on existing stock and bond prices are explicitly derived.