A Game Theoretic Approach to the Capital Structure and Investment Decision Problems of a Levered Firm

This paper provides a formal model that characterizes conflicts of interest between bondholders and shareholders and that derives the perverse incentive effect of debt financing. A two person non-cooperative game is utilized. The Rational Expectation Nash Equilibrium (RENE) concept is applied to find equilibrium solutions. When the firm issues a large amount of debt, the RENE solution is shown to be Pareto Inferior and MM Proposition I fails to obtain due to failure of MM Proposition III. This paper provides two sufficient conditions to restore the MM propositions in equilibrium. The use of convertible financial instruments conjectured by Jensen and Meckling (1976) is proved to be insufficient to restore the MM propositions globally in equilibrium. The use of protective covenants similar to the Grossman and Hart’s (1982) precommitment or bonding behavior is shown to be sufficient and it is indeed in the best interest of shareholders.