Optimal Security Design and Dynamic Capital Structure in a Continuous‐Time Agency Model

TLDR

The study derives an optimal dynamic contract in a continuous‑time principal‑agent framework and implements it using a capital structure that the agent controls. The mechanism involves a capital structure comprising a credit line, long‑term debt, and equity, with the firm holding compensating cash while borrowing at a higher rate through the credit line. Findings show that project volatility and liquidation cost minimally affect total debt capacity yet raise credit usage, leverage is nonstationary and falls with past profitability, and typical debt‑equity conflicts may not occur.

Abstract

ABSTRACT We derive the optimal dynamic contract in a continuous‐time principal‐agent setting, and implement it with a capital structure (credit line, long‐term debt, and equity) over which the agent controls the payout policy. While the project's volatility and liquidation cost have little impact on the firm's total debt capacity, they increase the use of credit versus debt. Leverage is nonstationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line. Surprisingly, the usual conflicts between debt and equity (asset substitution, strategic default) need not arise.