OPTIMAL FINANCIAL CONTRACTING - DEBT VERSUS OUTSIDE EQUITY

This article presents a theory of outside equity based on the control rights and the maturity design of equity. I show that outside equity i s a tacit agreement between investors and management supported by the equity-bolders' right to dismiss management regardless of performance and by the lack of a prespecified expiration date on equity. As a taci t agreement outside equity is sustainable despite management's potenti al for manipulating the cash flows and regardless of how costly it is for equityholders to establish a case against managerial wrongdoing. I establish that the only outside equity that investors are willing to hold in equilibrium is that with unlimited life, the very outside equi ty that corporations issue. Consistent with empirical evidence, this m odel predicts that debt-equity ratios are higher (lower) in industries with low thigh) cash flow variability.