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RFS Advance Access originally published online on September 7, 2007
Review of Financial Studies 2007 20(6):2079-2128; doi:10.1093/rfs/hhm031
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Copyright © The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies.

Optimal Long-Term Financial Contracting

Peter M. DeMarzo
Stanford University

Michael J. Fishman
Northwestern University

Address correspondence to Michael J. Fishman, Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, IL 60208, or e-mail: m-fishman{at}kellogg.northwestern.edu

JEL: G30, G32, G35, D82, D86, D92


  Abstract

We develop an agency model of financial contracting. We derive long-term debt, a line of credit, and equity as optimal securities, capturing the debt coupon and maturity; the interest rate and limits on the credit line; inside versus outside equity; dividend policy; and capital structure dynamics. The optimal debt-equity ratio is history dependent, but debt and credit line terms are independent of the amount financed and, in some cases, the severity of the agency problem. In our model, the agent can divert cash flows; we also consider settings in which the agent undertakes hidden effort, or can control cash flow risk.

We would like to thank Mark Garmaise, Denis Gromb, Bob McDonald, Maureen O'Hara, two reviewers, and seminar and conference participants for helpful comments. This article is based on research supported in part by the NBER and the National Science Foundation under grant No. 0452686.


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