Debt, Equity and Warrants

This paper considers project financing under adverse selection and moral hazard and makes three contributions. First, the issue of combinations of debt and equity is explained as the outcome of the interaction between adverse selection and moral hazard. Second, it shows that, in the presence of moral hazard, adverse selection may result in the conversion of negative into positive NPV projects leading to an improvement in social welfare. Third, it provides two rationales for the use of warrants. It also shows that, under certain conditions, a debt-warrant combination can implement the optimal contract as a competitive equilibrium. ∗ Warwick Business School, University of Warwick; [email protected]. I am indebted to Sudipto Bhattacharya and David de Meza for encouragement, extensive discussions and insightful comments. I would also like to thank Margaret Bray, Antoine Faure-Grimaud, Leo Ferraris, Michele Piccione, Jean-Charles Rochet and David Webb as well as seminar participants at AUEB, University of Amsterdam, University of Cyprus, LSE, University of Southampton, Tilburg University, University of York, University of Warwick and WBS for helpful comments.