Preserving "Debt Capacity" or "Equity Capacity": A Dynamic Theory of Security Design under Asymmetric Information

Inderst, Roman and Vladimirov, Vladimir (2012): Preserving "Debt Capacity" or "Equity Capacity": A Dynamic Theory of Security Design under Asymmetric Information.

Abstract

In a dynamic model of optimal security design, we show when firms should preserve "equity capacity" through choosing high target leverage or "debt capacity" through choosing low target leverage. Thereby, firms reduce a problem of underinvestment or overinvestment when they must raise future financing under asymmetric information. Which problem arises depends on whether additional financing is raised at competitive terms or whether there is a lock-in with initial investors. Firms’ initial (or target) capital structure matters as it affects the "outside option" of both insiders and outside investors. Our theory also entails implications for start-up and venture capital financing.

• Item Type: MPRA Paper
• Language: English
• Keywords: Dynamic Security Design, Capital Structure, Venture Capital Financing, Asymmetric Information
• Subjects: G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill

References

Aghion, Philippe, and Patrick Bolton, 1992, An incomplete contracts approach to finan- cial contracting, Review of Economic Studies 59, 473-494.

Axelson, Ulf, Per Strömberg, and Michael S. Weisbach, 2009, Why are buyouts levered? The financial structure of private equity funds, Journal of Finance 64, 1549-1582.

Berglöf, Eric, 1994, A control theory of venture capital finance, Journal of Law, Eco- nomics, and Organization 10, 247-267.

Bias, Bruno, and Thomas Mariotti, 2005, Strategic liquidity supply and security design, Review of Economic Studies 72, 615-649.

Burkart, Mike, and Samuel Lee, 2011, Smart buyers, Working paper Stockholm School of Economics and NYU.

Cho, In-Koo, and David M. Kreps, 1987, Signaling games and stable equilibria, Quarterly Journal of Economics 102, 179-221

Cornelli, Francesca, and Oved Yosha, 2003, Stage financing and the role of convertible securities, Review of Economic Studies 70, 1-32

Cumming, Douglas, 2005, Capital structure in venture finance, Journal of Corporate Finance 11, 550-585.

Cumming, Douglas, 2008, Contracts and exits in venture capital finance, Review of Fi- nancial Studies 21, 1948-1982.

Degryse, Hans, and Steven Ongena, 2008, Competition and regulation in the banking sector: A review of the empirical evidence on the sources of bank rents, in Anjan V. Thakor, and Arnoud W. A. Boot, eds. Handbook of Financial Intermediation and Banking (Elsevier, Amsterdam).

DeMarzo, Peter M., and Darrell Du¢ e, 1999, A liquidity-based model of security design, Econometrica 67, 65-99.

DeMarzo, Peter M., Ilan Kremer, and Andrzej Skrzypacz, 2005, Bidding with securities: Auctions and security design, American Economic Review 95, 936-959.

Detragiache, Enrica, Paolo Garella, and Luigi Guiso, 2000, Multiple versus single banking relationships: Theory and evidence, Journal of Finance 55, 1133-1161.

Fama, Eugene F., and Kenneth R. French, 2005. Financing decisions: Who issues stock?, Journal of Financial Economics 76, 549-582.

Fang, Lily H., Victoria Ivashina, Josh Lerner, 2010, Unstable Equity? Combining banking with private equity investing, SSRNWorking paper INSEAD and Harvard University.

Frank, Murray Z., and Vidhan K. Goyal, 2003, Testing the pecking order theory of capital structure, Journal of Financial Economics 67, 217-248.

Gomes, Armando, and Gordon Phillips, 2005, Why do public firms issue private and public securities?, Working paper Washington University-St. Louis and University of Maryland.

Gompers, Paul, 1995, Optimal investment, monitoring, and the staging of venture capital, Journal of Finance 50, 1461-1489.

Graham, John R., and Campbell Harvey, 2001, The theory and practice of corporate finance: Evidence from the .eld, Journal of Financial Economics 60, 187-243.

Hart, Oliver D., and John Moore, 1994, A theory of debt based on the inalienability of human capital, Quarterly Journal of Economics 109, 841-879.

Hellmann, Thomas, 2006, IPOs, acquisitions, and the use of convertible securities in venture capital, Journal of Financial Economics 81, 649-679.

Hellmann, Thomas, Laura Lindsey, and Manju Puri, 2008, Building relationships early: Banks in venture capital, Review of Financial Studies 21, 513-541.

Hennessy, Christopher A., and Toni M.Whited, 2005, Debt dynamics, Journal of Finance 60, 1129-1165.

Inderst, Roman, and Holger Müller, 2006, Informed lending and security design, Journal of Finance 61, 2137-2162.

Inderst, Roman, Holger Müller, and Felix Münnich 2007, Financing a portfolio of projects, Review of Financial Studies 20, 1289-1325.

Kaplan, Steven N., and Per Strömberg, 2003, Financial contracting theory meets the real world: An empirical analysis of venture capital contracts, Review of Economic Studies 70, 281-315.

Kaplan, Steven N., Frederic Martel, and Per Strömberg, 2007, How do legal differences and experience affect financial contracts?, Journal of Financial Intermediation 16, 273-311.

Leary, Mark T., and Michael R. Roberts, 2010, The pecking order, debt capacity, and information asymmetry, Journal of Financial Economics 95, 332-355.

Lemmon, Michael L., and Jaime F. Zender, 2009, Debt capacity and tests of capital structure, Journal of Financial and Quantitative Analysis, forthcoming.

Lerner, Josh, and Antoinette Schoar, 2005, Does legal enforcement a.ect financial transactions? The contractual channel in private equity, Quarterly Journal of Economics 120, 223-246.

Nachman, David C., and Thomas H. Noe, 1994, Optimal design of securities under asymmetric information, Review of Financial Studies 7, 1-44.

Miao, Jianjun, 2005, Optimal capital structure and industry dynamics, Journal of Finance 60, 2621-2659.

Myers, Stewart, and Nicholas Majluf, 1984. Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics 13, 187-221.

Petersen, Mitchell A., and Raghuram G. Rajan, 1994, The bene.ts of lending relationships: Evidence from small business data, Journal of Finance 49, 3-37.

Rajan, Raghuram G., 1992, Insiders and outsiders: The choice between informed and arm's-length debt, Journal of Finance 47, 1367-1400.

Ramey, Garey, 1996, D1 signaling equilibria with multiple signals and a continuum of types, Journal of Economic Theory 69, 508-531.

Sharpe, Steven A., 1990, Asymmetric information, bank lending and implicit contracts: A stylized model of customer relationships, Journal of Finance 45, 1069-1087.

Shyam-Sunder, Lakshmi, and Stewert C. Myers, 1999, Testing static trade-o. against pecking order models of capital structure, Journal of Financial Economics 51, 219-244.

Tirole, Jean, 2011, Overcoming adverse selection: How public intervention can restore market functioning, American Economic Review, forthcoming.