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Risk-Sharing As A Determinant Of Capital Structure: Internal Financing, Debt, And (Outside) Equity

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  • Yadira González de Lara

    ()
    (Universidad de Alicante)

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    Abstract

    This paper proposes a historically-grounded mechanism-design model of corporate finance, with two-side risk aversion under limited contract enforceability, where (inside) equity held by entrepreneurs, debt and (outside) equity coexist. This capital structure shares optimally the non-diversifiable risk associated with costly and risky ventures. Furthermore, it uniquely sustains the optimal risk allocation if agents' personal wealth is contractible at a higher enforcement cost than the projects' returns. Otherwise, the irrelevance theorem of Modigliani and Miller applies. Consistent with the theoretical predictions, we observe that (i) risk-averse merchants-entrepreneurs financed part of their ventures (hold inside equity) and raised additional funds from risk-averse investors through debt-like sea loan and equity-like commenda contracts when long-distance medieval trade was indeed highly costly and risky and that (ii) maritime insurance, with higher protection against the non-diversifiable "risk of loss at sea or from the action of men" but higher enforcement costs, did not develop until the mid-fourteenth century, when the ventures' costs and risk had decreased significantly. Whereas the model emphasizes the entrepreneurs' equity holdings and the limited-liability aspects of debt and equity, the choice between debt or equity derives from simple, although historically backed, information assumptions. The analysis is therefore complementary to other capital-structure theories based on agency costs, information asymmetries, signalling, transaction costs and incomplete contracting.

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    File URL: http://www.ivie.es/downloads/docs/wpasad/wpasad-2004-16.pdf
    File Function: Fisrt version / Primera version, 2004
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    Bibliographic Info

    Paper provided by Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie) in its series Working Papers. Serie AD with number 2004-16.

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    Length: 49 pages
    Date of creation: Apr 2004
    Date of revision:
    Publication status: Published by Ivie
    Handle: RePEc:ivi:wpasad:2004-16

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    Related research

    Keywords: debt contracts; capital structure; creditworthiness; enforceability; inside and outside equity; insurance; limited liability; private information; risk-sharing;

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    References

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    1. Harris, Milton & Raviv, Artur, 1991. " The Theory of Capital Structure," Journal of Finance, American Finance Association, vol. 46(1), pages 297-355, March.
    2. Leland, Hayne E & Pyle, David H, 1977. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, American Finance Association, vol. 32(2), pages 371-87, May.
    3. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, vol. 80(1), pages 93-106, March.
    4. Townsend, Robert M, 1982. "Optimal Multiperiod Contracts and the Gain from Enduring Relationships under Private Information," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1166-86, December.
    5. Bruce C. Greenwald & Joseph E. Stiglitz, 1994. "Asymmetric Information and the New Theory of the Firm: Financial Constraints and Risk Behavior," NBER Working Papers 3359, National Bureau of Economic Research, Inc.
    6. Daniel A. Ackerberg & Maristella Botticini, 2002. "Endogenous Matching and the Empirical Determinants of Contract Form," Journal of Political Economy, University of Chicago Press, vol. 110(3), pages 564-591, June.
    7. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
    8. Dewatripont, Mathias & Tirole, Jean, 1994. "A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 1027-54, November.
    9. Raghuram G. Rajan & Luigi Zingales, 1994. "What Do We Know About Capital Structure? Some Evidence from International Data," NBER Working Papers 4875, National Bureau of Economic Research, Inc.
    10. DeMarzo, Peter M. & Duffie, Darrell, 1991. "Corporate financial hedging with proprietary information," Journal of Economic Theory, Elsevier, vol. 53(2), pages 261-286, April.
    11. Lacker, J.M., 1989. "Optimal Contracts Under Costly State Falsification," Purdue University Economics Working Papers 956, Purdue University, Department of Economics.
    12. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
    13. Patrick Bolton & Xavier Freixas, 2000. "Equity, Bonds, and Bank Debt: Capital Structure and Financial Market Equilibrium under Asymmetric Information," Journal of Political Economy, University of Chicago Press, vol. 108(2), pages 324-351, April.
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