Debt, Equity, and Information
July 15, 2009
Straight debt and outside equity are the most fundamental types of financial
securities. Yet, the diversity of outside claims has received little attention. This
paper answers the question of why debt and equity are optimal instead of other
forms of financial contracts.
It simultaneously rationalizes the following styl-
ized facts: (i) equity carries state-contingent cash flow rights, while debt-holders’
cash flow rights are state-independent outside of bankruptcy; (ii) equity carries
unconditional monitoring rights, while debt-holders’ monitoring rights are con-
tingent on bankruptcy; (iii) equity serves as an incentive contract that alleviates
managerial moral hazard by inducing endogenous dividend signaling; (iv) equity
financing prevails when companies have a large growth potential and relatively
risky cash flows, and when a credible information policy to outside investors is
cost-efficient to implement (e.g. good corporate governance or small firm size).
∗Vienna Graduate School of Finance (VGSF), Heiligenstaedter Str. 46–48, 1190 Vienna, Austria.
Phone: +43 (1) 31336–5992, email: firstname.lastname@example.org, web: www.buehlmaier.net.
My greatest debt is to my advisor Klaus Ritzberger, who provided me with invaluable advice and
comments. I would like to express my deeply felt gratitude to him as he has constantly and generously
shared his knowledge with me. I would like to thank Filippo Balestrieri, Effi Benmelech, Eva Carceles-
Poveda, Thomas Dangl, Sarah Draus, Vito Gala, Christian Haefke, Christopher Hennessy, Philipp
Illeditsch, Eren Inci, Stefan Krasa, Felix Meschke, Gordon Phillips, Pegaret Pichler, Ehud Ronn,
Colin Rowat, Ariel Rubinstein, Jamsheed Shorish, Alex Stomper, Marti Subrahmanyam, Xuan Tam,
Sheridan Titman, Jörgen Weibull, Stefan Wendt, Wei Xiong, Haiping Zhang, Alexander Zimper, and
the participants in the VGSF paper writing conference, the Microeconomics Jour Fixe at the Institute
of Advanced Studies Vienna, the AF