The Optimality of Debt

Standard theories of debt consider a risk-neutral manager and a single contractible performance measure ("output"). We show that debt remains optimal under risk aversion if the likelihood ratio increases sufficiently with output and absolute risk aversion decreases sufficiently with wealth. Debt remains optimal if additional performance measures are available: they only affect the contractual debt repayment, leading to performance-sensitive debt. Even measures which are informative about effort almost everywhere may not be used due to contracting constraints, contrasting the informativeness principle. Debt can be suboptimal even if risk aversion is low, and even without a trade-off between incentives and risk-sharing.