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


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.


Target debt ratios Investment incentives Underinvestment Asymmetric information 

JEL Classification

G11 G32 


  1. Ang JS (1976) The intertemporal behavior of corporate debt policy. J Financ Quant Anal 11:555–566CrossRefGoogle Scholar
  2. Asquith P, Mullins DW (1986) Equity issues and offering dilution. J Financ Econ 15(1/2):61–89CrossRefGoogle Scholar
  3. Childs PD, Mauer DC, Ott SH (2005) Interactions of corporate financing and investment decisions: the effects of agency conflicts. J Financ Econ 76:667–690CrossRefGoogle Scholar
  4. Dann LY (1981) Common stock repurchase: an analysis of returns to bondholders and stockholders. J Financ Econ 9:113–183CrossRefGoogle Scholar
  5. De Jong A, Verbeek M, Verwijmeren P (2009) “Firms’ debt-equity decisions when the static tradeoff theory and the pecking order theory disagree”, available at: (Accessed 20 November 2010)
  6. De Miguel A, Pindado J (2001) Determinants of capital structure: new evidence from Spanish panel data. J Corp Financ 7:77–99CrossRefGoogle Scholar
  7. Diamond DW (1989) Reputation acquisition in debt markets. J Polit Econ 97(3):828–862CrossRefGoogle Scholar
  8. Eckbo E (1986) Valuation effects of corporate debt offerings. J Financ Econ 15(1/2):119–151CrossRefGoogle Scholar
  9. Flannery MJ, Rangan KP (2006) Partial adjustment toward target capital structures. J Financ Econ 79:469–506CrossRefGoogle Scholar
  10. Graham JR, Harvey CR (2001) The theory and practice of corporate finance: evidence from the field. J Financ Econ 60:187–243CrossRefGoogle Scholar
  11. Hackberth D, Mauer DC (2009) “Optimal priority structure, capital structure, and investment”, available at (Accessed 21 December 2010)
  12. Harris M, Raviv A (1991) The theory of capital structure. J Finance 46(1):297–355CrossRefGoogle Scholar
  13. Hirschleifer D, Thakor AV (1992) Managerial conservatism, project choice, and debt. Rev Financ Stud 5(3):437–470CrossRefGoogle Scholar
  14. Hovakimian A, Li G (2008) “Do firms have unique target debt ratios to which they adjust?”, Bruch College, available at (Accessed 12 December 2010)
  15. Jensen MC, Meckling WH (1976) Theory of the firm: managerial behavior, agency costs and ownership structure. J Financ Econ 3:305–360CrossRefGoogle Scholar
  16. Jong A, Verwijmeren P (2007) “To have a target debt ratio or not: what difference does it make?”, RSM Erasmus University, Rotterdam, the Netherlands, Available at (Accessed 12 November 2010)
  17. Ju N, Ou-Yang H (2006) “Asset substitution and underinvestment: a dynamic view”, EFA 2006 Zurich Meetings, Available at (Accessed 12 October 2010)
  18. Kim YC, Stulz RM (1988) The eurobond market and corporate financial policy: a test of the clientele hypothesis. J Financ Econ 22(2):189–205CrossRefGoogle Scholar
  19. Masulis RW (1980) Stock repurchase by tender offer: an analysis of the causes of common stock price changes. J Finance 35(2):305–319CrossRefGoogle Scholar
  20. Masulis RW, Korwar AN (1986) Seasoned equity offering: an empirical investigation. J Financ Econ 15(1–2):91–118CrossRefGoogle Scholar
  21. Mikkelson WH, Partch MM (1986) Valuation effects of security offerings and the issuance process. J Financ Econ 15(1/2):31–60CrossRefGoogle Scholar
  22. Millon-Cornet MH, Travlos NG (1989) Information effects associated with debt-for-equity and equity-for-debt exchange offers. J Finance 44(2):451–468CrossRefGoogle Scholar
  23. Myers SC (1977) Determinants of corporate borrowing. J Financ Econ 5:147–175CrossRefGoogle Scholar
  24. Myers SC (1984) The capital structure puzzle. J Finance 39(3):575–592CrossRefGoogle Scholar
  25. Myers SC, Majluf NS (1984) Corporate financing and investment decisions when firms have information that investors do not have. J Financ Econ 13:187–221CrossRefGoogle Scholar
  26. Schipper K, Smith A (1986) A comparison of equity carve-outs and seasoned equity offerings: share price effects and corporate restructuring. J Financ Econ 15(1/2):153–186CrossRefGoogle Scholar
  27. Scott DF, Johnson DJ (1982) Financing policies and practices in large corporations. Financ Manag 11(2):51–59CrossRefGoogle Scholar
  28. Stulz RM (1990) Managerial discretion and optimal financing policies. J Financ Econ 26(1):3–26CrossRefGoogle Scholar
  29. Titman S, Wessels R (1988) The determinants of capital structure choice. J Finance 43(1):1–19CrossRefGoogle Scholar
  30. Vermaelen T (1981) Common stock repurchases and market signaling: an empirical study. J Financ Econ 9(2):139–183CrossRefGoogle Scholar

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

Personalised recommendations