Risk-Sharing As A Determinant Of Capital Structure: Internal Financing, Debt, And (Outside) Equity
AbstractThis 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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Bibliographic InfoPaper provided by Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie) in its series Working Papers. Serie AD with number 2004-16.
Length: 49 pages
Date of creation: Apr 2004
Date of revision:
Publication status: Published by Ivie
debt contracts; capital structure; creditworthiness; enforceability; inside and outside equity; insurance; limited liability; private information; risk-sharing;
Find related papers by JEL classification:
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- N23 - Economic History - - Financial Markets and Institutions - - - Europe: Pre-1913
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-02-19 (All new papers)
- NEP-BEC-2006-02-19 (Business Economics)
- NEP-CFN-2006-02-19 (Corporate Finance)
- NEP-FIN-2006-02-19 (Finance)
- NEP-FMK-2006-02-19 (Financial Markets)
- NEP-UPT-2006-02-19 (Utility Models & Prospect Theory)
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