Abstract
This paper provides a new theory of the firm's capital structure. It shows that capital structure can act as a commitment mechanism for the firm to resolve the conflict between ex-ante managerial incentive and ex-post ownership control. As the conflict gives rise to an incentive-control trade-off in order to maximize firm value, there exists an optimal capital structure and thereby an optimal degree of commitment to achieve an optimal trade-off that maximizes firm value. The paper shows that the asymmetric information between the firm's owner and the outside investor can solve the commitment problem between the owner and the manager of the firm. The model offers several novel implications including the commitment role of outside financing and the functions of long-term debt and preferred stock.
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