We show how target debt ratios in book value terms applied to new investment can be used to improve alignment of investment incentives toward value maximization in firms with risky debt outstanding and asymmetric information. While wealth transfer from both agency conflicts can reduce the value of existing equity, new debt offsets the value loss to old shareholders. Since financing a part of investments with new debt set by book debt ratios offsets wealth transfer effects, firms will not pass up valuable investment opportunities and will make optimal investment decisions. Numerical examples show that both agency conflicts can be eliminated with new debt set by a target book debt ratio.
JEL Classification: G11; G32
Keywords: target debt ratios; agency costs; underinvestment; asymmetric information
