Resolving the Underinvestment and Asymmetric Information Problems with Target Debt Ratios

Abstract

We show how target debt ratios in book value terms applied to new investment can improve alignment of investment incentives in firms with 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. When an initial target book debt ratio is preserved following the investment, 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.