Corporate Finance from the Perspective of Bondholders: A Contribution to the Theory and Practice of Rational Financial Contracting

Abstract

This paper presents a theory of corporate finance from the perspective of bondholders. Towards this end an equilibrium model of a debt and equity financed firm is developed that motivates the need for an upfront bond contract that solves an agency problem between bondholders and stockholders. This bond contract guides the firm towards a no arbitrage equilibrium by directing managers to make investment decisions conforming to the risk aversion of their shareholders and then make financing decisions that preserve the investment quality of their bonds. Empirical evidence on the investment and financing of nonfinancial corporations conform to the predictions of the model.

Keywords: Covenants, Production - Investment Decisions, Financing Decisions, Security Markets, Business Cycles

JEL Classification: D7, E0, G1, G3, K0, L2