Good Cop, Bad Cop: Complementarities between Debt and Equity in Disciplining Management

In this paper we examine how the quantity of information generated about firm prospects can be improved by splitting a firm’s cash flow into a ‘safe’ claim (debt) and a ‘risky’ claim (equity). The former, being relatively insensitive to upside risk, provides a commitment to shut down the firm in the absence of good news. This commitment provides the latter a greater incentive to collect information than a monitor holding the aggregate claim would have. Thus debt and equity are shown to be complementary instruments in firm finance. We show that stock markets can play a useful role in transmitting information from equity to debt holders. This provides a novel argument as to why information contained in stock prices affects the real value of a corporation. It also allows us to make empirical predictions regarding the relation between shareholder dispersion, market liquidity and capital structure.