The Optimality of Debt versus Outside Equity

Abstract

This paper presents a theory of outside equity based on the control rights and the maturity design of equity. We show that outside equity is a tacit agreement between investors and management supported by equityholders’ right to dismiss management regardless of performance and by the lack of a prespecified expiration date on equity. Furthermore, as a tacit agreement outside equity is sustainable despite management’s potential for manipulating or diverting the cash flows and regardless of how costly it is for equityholders to establish a case against managerial wrongdoing. We establish that the only outside equity hat investors are willing to hold in equilibrium is outside equity with unlimited life, the very outside equity that corporations issues. Consistent with empirical evidence, this model predicts that debt-equity ratios will be higher in industries where cash flow variability is low relative to industries where cash flow variability is high. Furthermore, our theory implies that investors practice maturity- matching: they match the maturity of the optimal debt contract with the life of the physical assets and the maturity of the equity contract with the life of the company’s real options.