Optimal Incentive Schemes and the Coexistence of Debt and Equity

One of the main decisions facing firms is that of a choice of a capital structure, and in particular the choice of debt versus equity. Models where capital structure matters have focused either on the incentive approach, where agency problems stemming from the separation between ownership and control are important, or on control as a motive for the issue of debt or equity. These approaches have left open the question of the coexistence of debt and equity in a world where optimal financial incentive schemes are possible. In this paper, we examine this question from a complete contract perspective and argue that the complementarity between debt and equity can be explained as follows: equity will be useful as a way to favour value-increasing transfers of control, while debt will make sure such transfers take place even when they may go against private managerial interests.