Antonio Mello and John Parsons, Revised June 1990
In this paper we show how to adapt the traditional contingent claims valuation techniques to correctly value the firm and its liabilities in the presence of agency costs. This enables us to measure the significance of the agency costs as a function of the quantity of debt outstanding and as a function of the design of the debt contract: with this we can determine the relative benefits of alternative contract design. Our work makes a contribution to the recent database about how much debt a corporation can prudently assume. It is possible to measure the agency advantages of the new debt instruments for a given firm, and therefore to determine for which firms the advantages are significant and for which firms they are not.