Chapter 2 - Financial contracting theory

Summary

One of the oldest and most important questions in corporate finance is what determines how firms finance their investments and operations. This question has been referred to as the “capital structure” problem. The modern theory of capital structure began with the celebrated paper of Modigliani and Miller (1958). Here Modigliani and Miller (MM) pointed the direction that such theories must take by showing under what conditions capital structure is irrelevant. Since then, many economists have followed the path mapped by MM. Now, some thirty years later it seems appropriate to take stock of where this research stands and where it is going. Our goal in this survey is to synthesize the recent literature, summarize its results, relate these to the known empirical evidence, and suggest promising avenues for future research.

Capital structure theories have traditionally been concerned with what determines the relative amounts issued by firms of various given securities, mainly debt and equity. A much deeper question, however, is what determines the specific form of the contract (security) under which investors supply funds to the firm. Investors provide such funds with the expectation of sharing in the returns generated by the firms' investments. Therefore, financial contract design must resolve the problem of allocating the cash flows generated to investors. For example, debt contracts generally promise a fixed payment not contingent on firm performance. If the firm fails to make this payment, returns to debtholders are negotiated under the bankruptcy law of the relevant jurisdiction. Equity contracts specify that the holders share the residual returns after debtholders are paid, subject to limited liability. Returns to be allocated by financial contracts depend, however, on decisions made within the firm such as choice of project, assignment of personnel, day-to-day operating decisions, etc. As a result, returns depend on who is in control of these activities.