THE DESIGN OF INTERNAL CONTROL AND CAPITAL STRUCTURE

We study the design of internal control and capital structure. We pose the question, When is control allocated only to shareholders and when Is It allocated to other stakeholders, such as debtholders, or the ma nagement team? We show that shareholders (debtholders) get control whe n the firm's cash flow, is relatively sensitive (insensitive) to manag erial effort. Our theory implies that the signs of the correlations be tween endogenous variables when shareholders have absolute control are reversed when debtholders have veto power. In particular, debt level and firm value are negatively (positively) correlated when debtholders have veto power (shareholders have absolute control).