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Journal of Economics and Finance

, Volume 39, Issue 3, pp 431–453 | Cite as

Reducing agency conflicts with target debt ratios

  • Unyong PyoEmail author
  • Yong Jae Shin
  • Howard E. Thompson
Article
  • 341 Downloads

Abstract

We show how target debt ratios in book value terms applied to new investment can improve alignment of investment incentives in firms when they have risky debt outstanding and asymmetric information. While wealth transfer from both agency conflicts can reduce the value of existing equity, new debt offsets the value loss to old shareholders. New debt set by the target debt ratio naturally reflects key factors such as the NPV and size of the new project and offsets wealth transfers. Numerical examples show that both agency conflicts can be eliminated both in structural models and in binomial models.

Keywords

Target debt ratios Investment incentives Underinvestment Asymmetric information 

JEL Classification

G11 G32 

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Copyright information

© Springer Science+Business Media New York 2013

Authors and Affiliations

  • Unyong Pyo
    • 1
    Email author
  • Yong Jae Shin
    • 2
  • Howard E. Thompson
    • 3
  1. 1.Faculty of BusinessBrock UniversitySt. CatharinesCanada
  2. 2.Department of Business AdministrationSoongeui Women’s CollegeSeoulSouth Korea
  3. 3.School of BusinessUniversity of Wisconsin-MadisonMadisonUSA

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