THE ROLE OF DEBT AND PREFERRED STOCK AS A SOLUTION TO ADVERSE INVESTMENT INCENTIVES

We analyze the optimal mix of debt, common equity, and preferred equity in a model with an investment opportunity and asymmetric information about its quality, and show that an all-equity financed firm will overinvest. Issuing the appropriate amount of debt before the project becomes available resolves this overinvestment problem. Introducing a second motive for debt, such as taxes, leads to a role for preferred stock as a means of enhancing the firm's “debt capacity,” by creating additional incentives to invest. We derive an optimal capital structure involving debt, preferred stock, and common stock. © 1990, School of Business Administration, University of Washington. All rights reserved.