The Good Cop and the Bad Cop : Complementarities between Debt and Equity in Disciplining Management

In this paper we examine how the quantity of information generated about firm prospects can be improved by splitting a firm's cash flow into a 'safe' claim (debt) and a 'risky' claim (equity). The former, being relatively insensitive to upside risk, provides a commitment to shut down the firm in the absence of good news. This commitment provides the latter a greater incentive to collect information than the aggregate claimant would have. Thus debt and equity are shown to be complementary instruments in firm finance. Moreover, we investigate the role of stock markets in transmitting information from equity to debt holders. This provides a novel argument as to why information contained in stock prices affects the real value of a corporation. It also allows us to make empirical predictions regarding the relation between shareholder dispersion, market liquidity and capital structure