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The Role of Debt and Preferred Stock as a Solution to Adverse Investment Incentives

Robert Heinkel and Josef Zechner
The Journal of Financial and Quantitative Analysis
Vol. 25, No. 1 (Mar., 1990), pp. 1-24
DOI: 10.2307/2330885
Stable URL: http://www.jstor.org/stable/2330885
Page Count: 24
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Since scans are not currently available to screen readers, please contact JSTOR User Support for access. We'll provide a PDF copy for your screen reader.
The Role of Debt and Preferred Stock as a Solution to Adverse Investment Incentives
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Abstract

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.

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