Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/247201 
Year of Publication: 
2021
Series/Report no.: 
Queen’s Economics Department Working Paper No. 1459
Publisher: 
Queen's University, Department of Economics, Kingston (Ontario)
Abstract: 
We propose an information-based theory of capital structure to address the diversity of firm financing behavior and the variety of optimal financial contracts. Our model features nested information problems of adverse selection and agency cost. We prove that there exists a unique perfect Bayesian equilibrium with novel features: First, three types of optimal contracts arise endogenously, i.e., equity, transparent debt, and opaque debt. Equity and transparent debt are both informationally transparent because these contracts require firms to take on a costly technology for verifying types. Opaque debt, however, merely reflects the general information of firms seeking external funds. Any signaling contract that does not involve costly verification does not survive the equilibrium. Second, the unique equilibrium is either pooling on opaque debt, or mixing with transparent and opaque financing. Third, partial capital structure irrelevance exists in a mixing equilibrium. Fourth, debt weakly dominates equity for all firms that seek external financing. Finally, the optimal debt-to-equity ratio is unique for all firms in a pooling equilibrium, but only for a strict subset of firms in a mixing equilibrium.
Subjects: 
Optimal Contracts
Capital Structure
External Financing
Asymmetric Information
Information Transparency
JEL: 
D82
D86
G32
Document Type: 
Working Paper

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