Optimal financial contracting: dept versus outside equity

This article presents a theory of outside equity based on thecontrol rights and the maturity design of equity. I show thatoutside equity is a tacit agreement between investors and managementsupported by the equity-holders' right to dismiss managementregardless of performance and by the lack of a prespecifiedexpiration date on equity. As a tacit agreement outside equityis sustainable despite management's potential for manipulatingthe cash flows and regardless of how costly it is for equityholders to establish a case against managerial wrongdoing. Iestablish that the only outside equity that investors are willingto hold in equilibrium is that with unlimited life, the veryoutside equity that corporations issue. Consistent with empiricalevidence, this model predicts that debt-equity ratios are higher(lower) in industries with low (high) cash flow variability