The use of debt and equity in optimal financial contracts

We consider risk-neutral firms that must obtain external finance. They have access to two kinds of stochastic investment opportunities. For one, retur n realizations are costlessly observed by all agents. For the other, return realizations are costlessly observed only by the im investing firm. Wa exa mine the optimal allocation of investment between the two projects and the optimal contract used to finance it. The optimal contractual outcome can be supported by appropriate (and determinate) quantities of debt and equity i ssues. Investments in projects with CSV problems are associated loosely wit h debt. Investments in projects with observable returns are associated with equity. Journal of Economic Literature Classification Numbers: G21.E51. (C ) 1999 Academic Press.