A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence

Abstract

This paper shows how the optimal financial structure of a firm complements incentive schemes to discipline managers, and how the securities' return streams determine the claim-holders' incentives to intervene in management. The theory rationalizes (1) the multipUcity of securities, (2) the observed correlation between return streams and control rights of securities, and (3) the partial congruence between managerial and equity-holder preferences over policy choices and monetary rewards as well as the low level of interference of equity in management. The theory also offers new prospects for a reappraisal of the earlier corporate finance literature.