ABSTRACT
Why is debt finance so common? This question has been continuing theme in corporate finance. To explain the wide use of debt, trade-off theory proposes the tax benefit of debt whereas agency theory proposes debt aligns the incentive of a firm’s decision maker to ensure he acts in the interest of owners. In this chapter, I show another approach of explaining the use of debt, utilizing the rapid progress of contract theory during the 1970s and 1980s. In particular, I claim debt can be an optimal financial contract in various settings.
