Buddhist Wolf

A combined treatment of corporate finance and corporate governance is herein proposed. Debt and equity are treated not mainly as alternative financial instruments, but rather as alternative governance structures. Debt governance works mainly out of rules, while equity governance allows much greater discretion. A project‐financing approach is adopted. I argue that whether a project should be financed by debt or by equity depends principally on the characteristics of the assets. Transaction‐cost reasoning supports the use of debt (rules) to finance redeployable assets, while non‐redeployable assets are financed by equity (discretion). Experiences with leasing and leveraged buyouts are used to illustrate the argument. The article also compares and contrasts the transaction‐cost approach with the agency approach to the study of economic organization. This paper examines corporate finance through the lens of transaction‐cost economics. A fundamental tenet of this approach is that the supply of a good or service and its governance need be examined simultaneously. Corporate finance is no exception—whence the combined reference to corporate finance and corporate governance in the title. Agency theory provides an alternative lens to which transaction‐cost economics is sometimes compared. The leading similarities and differences between these two approaches are examined in Section I. The core of the paper, Section II, deals with “project financing.” Extensions, qualifications and applications are treated in Section III. Concluding remarks follow.