This paper develops a theory of the capital structure decisions of a large public company with dispersed shareholders. The management team of such a company has a fairly free hand to pursue its own goals, possibly at the expense of those of shareholders. We argue that placing debt in the company's capital structure is one way for investors to constrain management. We develop three models to analyze this. In each model there is a conflict of interest over the size of the firm; management wants a bigger "empire" than do investors. After we have developed the models, we discuss whether they are capable of explaining the stylized facts about capital structure. We conclude by comparing the agency approach developed in the paper with other theories in the literature.
This paper was presented at the conference held in Rome on 24-25 March 1994 to examine the results of the Bank of Italy's research project on the market for corporate control. The final reports discussed on that occasion have been published by Il Mulino, Bologna.
An early version of this paper was the foundation for the Woodward Lecture presented at the University of British Columbia in November 1991. The paper is a self-containedversion of Chapter 6 of the forthcoming book, Firms.Contracts_and Financial Structure, to be published by Oxford University Press.
