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Informed Lending and Security Design

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  • ROMAN INDERST
  • HOLGER M. MUELLER

Abstract

We examine the role of security design when lenders make inefficient accept or reject decisions after screening projects. Lenders may be either “too conservative,” in which case they reject positive‐NPV projects, or “too aggressive,” in which case they accept negative‐NPV projects. In the first case, the uniquely optimal security is debt. In the second case, it is levered equity. In equilibrium, profitable projects that are relatively likely to break even are financed with debt, while less profitable projects are financed with equity. Highly profitable projects are financed by uninformed arm's‐length lenders.

Suggested Citation

  • Roman Inderst & Holger M. Mueller, 2006. "Informed Lending and Security Design," Journal of Finance, American Finance Association, vol. 61(5), pages 2137-2162, October.
    • Handle: RePEc:bla:jfinan:v:61:y:2006:i:5:p:2137-2162
    DOI: 10.1111/j.1540-6261.2006.01053.x
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    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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