Abstract
We put forward a theory of the optimal capital structure of the …rm based on Jensen's (1986) hypothesis that a …rm's choice of capital structure is determined by a trade-obetween agency costs and monitoring costs. We model this tradeodynam- ically. We assume that early on in the production process, outside investors face an information friction with respect to withdrawing funds from the …rm that dissapates over time. We assume that they also face an agency friction that increases over time with respect to funds left inside the …rm. The problem of determining the optimal capital structure of the …rm as well as the optimal compensation of the manager is then a problem of choosing payments to outside investors and the manager at each stage of production to balance these two frictions. We show how this structure can generate a very rich theory of capital structure and compensation.
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