Debt and Equity

Abstract

Which is better for a small firm: debt financing or equity financing? A simple intertemporal model suggests that the two have very different potential incentive problems. With equity financing, the manager (an employee) may expend too little effort, while with debt financing, the manager (the owner) may keep the entire cash ow and default on the debt. Depending on the relative severity of these two incentive problems, either debt or equity may dominate the other. These problems are exacerbated by the possibility of an MBO and are reduced by sinking funds, stock or option compensation and non-vested pensions.