Debt and equity are developed as optimal financial instruments in a model where cash flows and control rights are allocated to investors endogenously. When investment decisions must be made by a single party, the debtholder's cash flows are fixed in order to provide the equityholder with efficient incentives for investment. Ownership of control may be transferred to the debtholder to attenuate the impact of asymmetric information, concerning the investment opportunity, on the efficiency of the decision-making.

[The Modigliani and Miller propositions on the irrelevancy of capital structure and dividends are shown to be valid in a large class of models with asymmetric information. The main assumption is that managerial compensation is chosen optimally. This differs from most of the recent articles on this topic, which impose by fiat a suboptimal contract. Even when imperfections internal to the firm preclude optimal investment, there is a separation between incentives and financing. We conclude that corporations should move toward contracts with better incentives, and that new models should be built that recognize the limitations to optimal contracting.]

Debt and equity are developed as optimal financial instruments in a model where cash flows and control rights are allocated to investors endogenously. When investment decisions must be made by a single party, the debtholder's cash flows are fixed in order to provide the equityholder with efficient incentives for investment. Ownership of control may be transferred to the debtholder to attenuate the impact of asymmetric information, concerning the investment opportunity, on the efficiency of the decision making.

Debt and equity are developed as optimal financial instruments in a model where cash flows and control rights are allocated to investors endogenously. When investment decisions must be made by a single party, the debtholder's cash flows are fixed in order to provide the equityholder with efficient incentives for investment. Ownership of control may be transferred to the debtholder to attenuate the impact of asymmetric information, concerning the investment opportunity, on the efficiency of the decision making.

The Modigliani and Miller propositions on the irrelevancy of capital structure and dividends are shown to be valid in a large class of models with asymmetric information. The main assumption is that managerial compensation is chosen optimally. This differs from most of the recent articles on this topic, which impose by fiat a suboptimal contract. Even when imperfections internal to the firm preclude optimal investment, there is a separation between incentives and financing. We conclude that corporations should move toward contracts with better incentives, and that new models should be built that recognize the limitations to optimal contracting.