Capital Structure and the Informational Role of Debt

Authors

  • MILTON HARRIS,

  • ARTUR RAVIV

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    • Harris is the Chicago Board of Trade Professor of Finance and Business Economics, Graduate School of Business, University of Chicago. Raviv is the Alan E. Peterson Professor of Finance, Kellogg Graduate School of Management, Northwestern University, and Professor, Faculty of Management, Tel Aviv University. We are grateful to the National Science Foundation and the Bradley Foundation for financial support. Harris would also like to thank Dimensional Fund Advisors for additional financial support. Helpful comments from participants at seminars at the University of Chicago, Stanford University, MIT and the 1989 European Economic Association Meetings, especially George Constantinides, Doug Diamond, Allan Kleidon, John Persons, Cynthia Van Hulle, Robert Vishny, and Yoram Weiss are gratefully acknowledged. We also thank René Stulz, the editor, and an anonymous referee for valuable suggestions.

ABSTRACT

This paper provides a theory of capital structure based on the effect of debt on investors' information about the firm and on their ability to oversee management. We postulate that managers are reluctant to relinquish control and unwilling to provide information that could result in such an outcome. Debt is a disciplining device because default allows creditors the option to force the firm into liquidation and generates information useful to investors. We characterize the time path of the debt level and obtain comparative statics results on the debt level, bond yield, probability of default, probability of reorganization, etc.

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