The Roles of Debt, Equity and Warrants Under Asymmetric Information

This paper analyses the roles of debt, equity and warrants under asymmetric information and provides two rationales for the issuance of combinations of debt and equity as well as for the use of warrants. Two cases are considered: i) pure adverse selection and ii) adverse selection cum moral hazard. In the former case, a combination of securities is only used to convey socially costless information about the type of the project. In the latter case, in addition to transmitting information, the securities issued are the means of providing the appropriate effort incentives. Because of this second role, the introduction of moral hazard into an adverse selection framework has significant effects both on the combinations of securities issued in equilibrium and their pricing. Under pure adverse selection, the use of warrants, through the appropriate choice of their exercise price, allows us to obtain equilibria (pooling or separating) where the securities issued are fairly priced even if this is not possible when we restrict ourselves to debt, equity and convertible debt. In the adverse selection cum moral hazard case, employing a debt-warrant combination, we can implement the (constrained) efficient outcome under weaker restrictions on the parameter values than a debt-equity combination and, in some cases, under the same conditions as the social planner. ∗ Department of Economics, London School of Economics; [email protected]. I would like to thank Sudipto Bhattacharya, Margaret Bray, David de Meza, Antoine Faure-Grimaud, Leo Ferraris, Michele Piccione, Jean-Charles Rochet and David Webb as well as seminar participants at LSE for helpful discussions and comments.