Abstract
This paper examines the effect of capital structure on investment decisions when the firm is controlled by a large, risk-averse shareholder. Because of under-diversification, the controlling shareholder is more averse to risky projects than atomistic shareholders whose portfolios are fully diversified, and hence the former may under-invest by rejecting projects which are desirable for the latter. We show that this under-investment problem can be mitigated by issuing risky debt because of the `risk-shifting' effect of debt. The paper demonstrates a unique equilibrium capital structure, involving both risky debt and equity, which is directly linked to the ownership structure. The analysis leads to empirical predictions about how ownership and capital structure are interrelated, and how capital structure is affected by such exogenous factors as the identity of the controlling shareholder and project risk. The existing empirical studies generally support these predictions.
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