The Journal of Finance publishes leading research across all the major fields of finance. It is one of the most widely cited journals in academic finance, and in all of economics. Each of the six issues per year reaches over 8,000 academics, finance professionals, libraries, and government and financial institutions around the world. The journal is the official publication of The American Finance Association, the premier academic organization devoted to the study and promotion of knowledge about financial economics.
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Moral Hazard and Adverse Selection: The Question of Financial Structure
Published: 06/01/1986 | DOI: 10.1111/j.1540-6261.1986.tb05051.x
MASAKO N. DARROUGH, NEAL M. STOUGHTON
This paper looks at the moral hazard and adverse selection problems confronting an entrepreneur offering securities to an uninformed, but competitive financial market. The adverse selection aspect of the problem is generated by the unobservable entrepreneur's ability to transform effort into value. Moral hazard arises because the investment decision is made subsequent to financing. We consider the joint use of both debt and equity, and characterize the equilibrium relation between capital structure and unobservable attributes. It is shown that: (1) investment and financing are not separable; (2) there is an underinvestment problem for “better” firms; and (3) simultaneous use of both debt and equity can resolve this difficulty. We also establish a connection between expected terminal firm value and debt‐promised payment level and between share retention and standard deviation.