Payoff Structure, External Corporate Governance and Financing Decision of Firms

In a three-period model with active and passive external corporate governance, this paper studies the endogenous decision of debt and equity financiers on the governance mode and intensity over their debtors, as well as how this may affect the funded firms' financing choice. We show that debt financiers prefer passive governance, while equity financiers' choice depends on which can raise the expected project value more. Debt financiers exert a higher governance intensity under passive governance, but under active governance equity financiers monitor more intensively for sufficiently good projects. Contrary to the prediction of pecking order theory, it is shown that good projects should be financed with equity, to take advantage of equity financiers' competency in active governance. We also explore several implications for the relationship between firm leverage and its asset in place and its project success probability, and find that governance variables should be important in explaining firm capital structure empirically.