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Reducing agency conflicts with target debt ratios

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  • Unyong Pyo
  • Yong Shin
  • Howard Thompson

Abstract

We show how target debt ratios in book value terms applied to new investment can improve alignment of investment incentives in firms when they have risky debt outstanding and asymmetric information. While wealth transfer from both agency conflicts can reduce the value of existing equity, new debt offsets the value loss to old shareholders. New debt set by the target debt ratio naturally reflects key factors such as the NPV and size of the new project and offsets wealth transfers. Numerical examples show that both agency conflicts can be eliminated both in structural models and in binomial models. Copyright Springer Science+Business Media New York 2015

Suggested Citation

  • Unyong Pyo & Yong Shin & Howard Thompson, 2015. "Reducing agency conflicts with target debt ratios," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 39(3), pages 431-453, July.
    • Handle: RePEc:spr:jecfin:v:39:y:2015:i:3:p:431-453
    DOI: 10.1007/s12197-013-9256-0
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    More about this item

    Keywords

    Target debt ratios; Investment incentives; Underinvestment; Asymmetric information; G11; G32;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • 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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