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for helpful suggestions on an earlier draft. Funding from the United States Department of Health and Human Services is gratefully acknowledged.

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A Tc temporary capital PCB permanent capital @oak value) Assistant Professor of Finance, Northwestern University. While retaining full responsibility for the final product, the author is indebted to Frank Brechling, Stuart Greenbaum, Jerry Hausman, Franc0 Modigliani, Stewart Myers and Eugene Savin for many helpful suggestions. 1. This balance sheet is meant to illustrate the basic nature of the financing decision. A more complete balance sheet is included with the discussion of the estimates. 1467 1468 The Journal of Finance 2. See [2], [3], [7] and [ 121. 3. Spies uses the "stacking technique," a variant of OM, which allows him to estimate all of his 4. See [16]. equations at once.

for helpful comments. 1. See for example the papers by Pye [11], and Bodie and Friedman [1] and the references cited by them. 2. See Krause [4]. 3. In 1973, for example, the Bristol-Meyers Company used internally-generated funds to call $25 million of its $75 million outstanding 8 5/8% debentures due in 1995. The issue was nonrefundable until 1980 but not nonredeemable. A similar possibility for many utility bonds was recently raised in the Wall Street Jourfnal [12]. 1188The Journal of Finance Second, even floating rate securities may have call provisions. Citicorp's $650 million issue of Floating Rate Notes, due in 1989, is "callable as a whole or in part at any time after June 1, 1984, at Co.'s option... at 100 plus accrued interest" [7]. Again, the issuer's motivation for including the call provision must stem from something beyond potential changes in market rates. This paper attempts to explore one such possibility in--some detail. The central point is that when a firm has future discretionary investment opportunities, the call feature is not necessarily a zero-sum game. It is possible for a firm to make its shareholders better off by including a call option on its debt, even if bondholders have full prior knowledge of the chances that the option will be exercised. In addition, the call option cannot make shareholders worse off than if their company had issued noncallable debt.The reason behind this asymmetry is that noncallable debt creates an externality to shareholding. When there is a chance of default, bondholders have a partial share in the residual value of the firm's assets, and thus they participate in any changes in its fortunes. If the firm makes profitable future investments, only part of the net benefit will be captured by shareholders, and the rest will accrue to the bondholders. Since shareholders are unable to reap the full benefit of additional investment, they will wish to invest less than would otherwise be optimal. If the bonds are callable, however, the shareholders can retire their debt at a fixed price and then negotiate an interest rate on any new debt which fully reflects the value of the additional investment. The shareholders' incentive to invest is no longer weakened in this case, because they are in a position to capture its full marginal benefit.In order to focus on future investment opportunities as one possible source of the call provision's value, we assume away all interest rate uncertainty in our model, and all tax considerations are likewise ignored. Furthermore, we assume homogeneous expectations and risk neutrality on the part of both issuers and investors.In section II we present a simple numerical example to illustrate the main point. A firm makes its current investment and financing decisions and faces a possibility of further profitable investment in the future. The net present value of the shareholders' wealth is computed in turn under initial all-equity, 50% noncallable debt and 50% callable debt financing, and it is found that noncallable debt weakens the firm's f...