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

Robert Heinkel and Josef Zechner

Journal of Financial and Quantitative Analysis, 1990, vol. 25, issue 1, 1-24

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.

Date: 1990
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