Optimal Financial Instruments



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    • Assistant Professor of Finance, The University of Utah and Washington University in St. Louis. This project began while I was a graduate student at Yale University and I am greatly indebted to Joel Demski, Phil Dybvig, Bengt Holmström, and Steve Ross for their help and support. I also thank Jim Brickely, Avner Kalay, seminar participants at the University of Colorado, the University of Utah, Washington University in St. Louis, the 1990 Winter Meetings of the Econometric Society, and especially Dick Jefferis for valuable comments. René Stulz (the editor) and Artur Raviv (the referee) provided suggestions that have made the paper much more accessible. I am grateful for partial financial support from the Garn Institute of Finance.


Debt and equity are developed as optimal financial instruments in a model where cash flows and control rights are allocated to investors endogenously. When investment decisions must be made by a single party, the debtholder's cash flows are fixed in order to provide the equityholder with efficient incentives for investment. Ownership of control may be transferred to the debtholder to attenuate the impact of asymmetric information, concerning the investment opportunity, on the efficiency of the decision making.