Limited Liability Rules, Financial Innovation and Capital Structure Complexity
EFA 2002 Berlin Meetings Presented Paper
27 Pages Posted: 11 Jan 2002
Date Written: February 2002
Abstract
During the course of the nineteenth century, many countries abolished debtors' prisons and imposed legal limits on borrowers' maximum liability. The same period saw the emergence of equity warrants. This paper shows how limited liability rules make warrants a critical part of firms' capital structure. We use a standard agency model of investment financing under moral hazard and risk aversion in which it is optimal for active shareholders to have unlimited liability. When the legal environment does not constrain active shareholders' choice of liability regime, it is found that they can finance investment with a simple combination of straight debt and limited-liability external equity as long as they themselves retain unlimited liability. That is, a simple capital structure suffices because harsh penalties can be imposed and outside investors can recover a significant fraction of their investment in case of default. In contrast, when legal rules exogenously limit entrepreneurs' maximum liability, a warrant issue becomes a key additional element of the optimal capital structure. The warrants optimally compensate outside investors for higher expected losses in the event of default.
Note: Previously titled Harsh Default Penalties or Warrants: The Impact of Limited Liability Rules
Keywords: Agency, Moral Hazard, Liability Rules, Optimal Capital Structure, Warrants as Financial Innovation
JEL Classification: G32, G38, D82, K22, N20
Suggested Citation: Suggested Citation