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Rev Fin 1998; 11:383-418
© 1998 the Society for Financial Studies

Article

Optimal financial contracting: dept versus outside equity

Z Fluck
Department of Finance, Stern School of Business, New York University, 44 West 4th Street, Suite 9-190, New York, NY 10012, USA
e-mail: zfluck@stern.nyu.edu.

Abstract

This article presents a theory of outside equity based on the control rights and the maturity design of equity. I show that outside equity is a tacit agreement between investors and management supported by the equity-holders' right to dismiss management regardless of performance and by the lack of a prespecified expiration date on equity. As a tacit agreement outside equity is sustainable despite management's potential for manipulating the cash flows and regardless of how costly it is for equity holders to establish a case against managerial wrongdoing. I establish that the only outside equity that investors are willing to hold in equilibrium is that with unlimited life, the very outside equity that corporations issue. Consistent with empirical evidence, this model predicts that debt-equity ratios are higher (lower) in industries with low (high) cash flow variability


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