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Other Unpublished Work
| 2011
Good Cop, Bad Cop: Monitoring and Liquidation Incentives in Corporate Finance
by
Lucy White and Alexander Guembel
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Abstract
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 a monitor holding the aggregate claim would have. Thus debt and equity are shown to be complementary instruments in firm finance. We show that stock markets can play a useful role 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.
Keywords: Borrowing and Debt;
Capital Structure;
Cash Flow;
Equity;
Financial Liquidity;
Financial Markets;
Information;
Motivation and Incentives;