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Good cop, bad cop: Complementarities between debt and equity in disciplining management

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  • Guembel, Alexander
  • White, Lucy

Abstract

We demonstrate an inherent conflict between ex ante efficient monitoring and liquidation decisions by outside claimholders. We show it can be useful to commit to inefficient liquidation when monitors fail to produce information: this provides stronger incentives to monitor. The implication for firm capital structure is that more information is generated about firm prospects – and hence firm value increases – when a firm’s cash flow is split into a ‘safe’ claim (debt) and a ‘risky’ claim (equity) compared to when a single claim is sold. We also derive the optimal allocation of control rights between safe and risky claims. This partially resolves the Tirole (2001) puzzle as to why firms issue multiple securities that generate ex post conflicts of interest.

Suggested Citation

  • Guembel, Alexander & White, Lucy, 2014. "Good cop, bad cop: Complementarities between debt and equity in disciplining management," Journal of Financial Intermediation, Elsevier, vol. 23(4), pages 541-569.
    • Handle: RePEc:eee:jfinin:v:23:y:2014:i:4:p:541-569
    DOI: 10.1016/j.jfi.2014.02.004
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