A Note on the Optimality of the Debt-Equity Mix

Abstract

Dewatripont and Tirole showed (for the first time) that a mix of debt and equity is optimal and thus provided justification of the most commonly observed capital structure. Using Diamond framework, this note simplifies their model and shows that the main reason why debt-equity mix is optimal is not the divergence of attitude towards risk between shareholders and debtholders as claimed in their papers. It is rather the flexibility debt contract affords in allocating control rights and incentives to liquidate the firm.