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Debt issues and capital structure with soft information

  • Yawen Jiao
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    Purpose – The purpose of this paper is to investigate the role of “soft information” in firms’ debt issue and capital structure choices, and present a new model reconciling the gap between theories of capital structure and empirical findings. Design/methodology/approach – The paper develops an analytical model of debt issues under asymmetric information in a setting where, in addition to observing the amount of debt the firm issues, outside investors obtain “soft information” signals through their own information production or noisy voluntary disclosures made by the firm. This paper analyzes the benefit and cost for the firm's debt issue decisions in this setting, and specifies the effect of soft information on these decisions. Findings – If sufficiently precise soft information is available to outside investors, the firm's debt issue behavior is significantly altered relative to that in existing models. In particular, an inverted-U shape relationship is found between the intrinsic value of the firm and the amount of debt it issues. Moreover, there is a negative relationship between the amount of debt the firm issues and the precision of soft information. Further, it is found that firms about which outside investors receive more favorable soft information issue less debt. Research limitations/implications – The model predicts an inverted-U shape relationship between firms’ debt ratios and operating performance. It also predicts that firms about which outside investors receive more favorable or more precise soft information have lower debt ratios on average. A rationale is provided for the existence of firms’ investor relations departments. Originality/value – Firms’ capital structure choices remain a topic of significant importance. This paper incorporates the soft informations into firms’ debt issue decisions and proposes a new model of capital structure that generates insights into firms’ financing decisions and disclosure decisions, as well as information production by outside investors.

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    File URL: http://www.emeraldinsight.com/journals.htm?issn=0307-4358&volume=36&issue=1&articleid=1834329&show=abstract
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    Article provided by Emerald Group Publishing in its journal Managerial Finance.

    Volume (Year): 36 (2010)
    Issue (Month): 1 (January)
    Pages: 4-21

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    Handle: RePEc:eme:mfipps:v:36:y:2010:i:1:p:4-21
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    1. Stewart C. Myers, 1993. "Still Searching For Optimal Capital Structure," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(1), pages 4-14.
    2. Michael J. Barclay & Clifford W. Smith & Ross L. Watts, 1995. "The Determinants Of Corporate Leverage And Dividend Policies," Journal of Applied Corporate Finance, Morgan Stanley, vol. 7(4), pages 4-19.
    3. Milgrom, Paul & Roberts, John, 1986. "Price and Advertising Signals of Product Quality," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 796-821, August.
    4. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    5. Fudenberg, Drew & Tirole, Jean, 1991. "Perfect Bayesian equilibrium and sequential equilibrium," Journal of Economic Theory, Elsevier, vol. 53(2), pages 236-260, April.
    6. Cho, In-Koo & Sobel, Joel, 1990. "Strategic stability and uniqueness in signaling games," Journal of Economic Theory, Elsevier, vol. 50(2), pages 381-413, April.
    7. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
    8. Engers, Maxim, 1987. "Signalling with Many Signals," Econometrica, Econometric Society, vol. 55(3), pages 663-74, May.
    9. Xin Chang & Sudipto Dasgupta & Gilles Hilary, 2006. "Analyst Coverage and Financing Decisions," Journal of Finance, American Finance Association, vol. 61(6), pages 3009-3048, December.
    10. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
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