Short-Term Termination Without Deterring Long-Term Investment: A Theory Of Debt (Not Dividends)

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Executive Summary

The option to terminate a manager early minimizes investor losses if he is unskilled. However, it also deters a skilled manager from undertaking long-term projects that risk low earnings. This paper introduces a novel role of debt that allows it to overcome this tension. Leverage concentrates equity holders' stakes, creating incentives for them to learn the cause of low earnings. If they result from investment (poor management), the firm is continued (liquidated). Therefore, unskilled managers are terminated and skilled managers can invest without fear of termination.

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