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The Role of Debt and Perferred Stock as a Solution to Adverse Investment Incentives

Published online by Cambridge University Press:  06 April 2009

Robert Heinkel  and
Josef Zechner
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Abstract

We analyze the optimal mix of debt, common equity, and preferred equity in a model with an investment opportunity and asymmetric information about its quality, and show that an all-equity financed firm will overinvest. Issuing the appropriate amount of debt before the project becomes available resolves this overinvestment problem. Introducing a second motive for debt, such as taxes, leads to a role for preferred stock as a means of enhancing the firm's “debt capacity,” by creating additional incentives to invest. We derive an optimal capital structure involving debt, preferred stock, and common stock.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 25 , Issue 1 , March 1990 , pp. 1 - 24
Copyright
Copyright © School of Business Administration, University of Washington 1990

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