Optimal Securities under Adverse Selection and Moral Hazard

We consider project financing under adverse selection and moral hazard and derive several interesting results. First, we provide an explanation of why good firms issue both debt and underpriced equity (even if the bankruptcy and agency costs of debt are zero). Second, we show that, in the presence of moral hazard, adverse selection may induce the conversion of negative into positive NPV projects leading to an improvement in social welfare. Third, we provide a rationale for the use of warrants. We also show that a debtwarrant combination can implement the optimal contract. Our results have a number of testable implications.