1) Financial frictions like asymmetric information and monitoring costs cause deviations from perfect capital markets. This leads to an external finance premium for firms. 2) Optimal debt contracts have option-like characteristics, with lenders only monitoring borrowers in "bad states". 3) The model shows how balance sheet strength, as measured by leverage ratios, determines borrowing costs and the size of the external finance premium in equilibrium. Weaker balance sheets are associated with higher spreads.