We consider risk-neutral firms that must obtain external finance. They have access to two kinds of stochastic investment opportunities. For one, return realizations are costlessly observed by all agents. For the other, return realizations are costlessly observed only by the investing firm. We examine the optimal allocation of investment between the two projects and the optimal contract used to finance it. The optimal contractual outcome can be supported by appropriate (and determinate) quantities of debt and equity issues. Investments in projects with CSV problems are associated loosely with debt. Investments in projects with observable returns are associated with equity. Journal of Economic Literature Classification Numbers: G21, E51.
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The optimal contract between a firm and the agents who finance it specifies a repayment schedule that is a piecewise linear function of all the project returns that can be observed by outsiders. This contract can be supported by having the firm issue an appropriately selected— and determinate—amount of external debt and equity. The amount of equity issued depends on the composition of the firm’s investments, on the costs of state verification, and on factors—such as the distribution of returns on technology o—that are irrelevant to the allocation of resources.