Incomplete Contracts, Bankruptcy and the Firm’s Capital Structure

This paper considers the effects multilateral opportunistic behaviour on the firm’s capital structure. We show that multiple parties introduce greater incompleteness, because the firm cannot control future contracts in potential opportunistic coalitions. A higher debt-equity ratio increases the probability of opportunistic coalitions, hence increasing the costs of opportunistic behaviour. By choosing equity financing, the firm can avoid the costs of opportunistic behaviour altogether. Thus, in the absence of all other motives for using debt, the firm will be equity financed. Since, in general, there are other motives for holding debt, this implies that under these conditions, the debt-equity ratio will tend to be lower. We also show that if the firm can be franchised, equity financing yields a first best outcome. On the other hand, if debt is used (for other motives), or if the firm cannot be franchised, the first best solution cannot be achieved. The results in this paper suggest that, in general, the firm’s debt equity ratio will decrease with the number of interdependent contracts, the difficulty in writing contracts with the provider of the non-contractible input and his importance in an opportunistic coalition.