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Information Transparency of Firm Financing

Author

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  • Antoine L. Noël
  • Amy Hongfei Sun

Abstract

We propose an information-based theory of capital structure to address the diversity of firm financing behavior and the variety of optimal financial contracts. Our model features nested information problems of adverse selection and agency cost. We prove that there exists a unique perfect Bayesian equilibrium with novel features: First, three types of optimal contracts arise endogenously, i.e., equity, transparent debt, and opaque debt. Equity and transparent debt are both informationally transparent because these contracts require firms to take on a costly technology for verifying types. Opaque debt, however, merely reflects the general information of firms seeking external funds. Any signaling contract that does not involve costly verification does not survive the equilibrium. Second, the unique equilibrium is either pooling on opaque debt, or mixing with transparent and opaque financing. Third, partial capital structure irrelevance exists in a mixing equilibrium. Fourth, debt weakly dominates equity for all firms that seek external financing. Finally, the optimal debt-to-equity ratio is unique for all firms in a pooling equilibrium, but only for a strict subset of firms in a mixing equilibrium.

Suggested Citation

  • Antoine L. Noël & Amy Hongfei Sun, 2021. "Information Transparency of Firm Financing," Working Paper 1459, Economics Department, Queen's University.
  • Handle: RePEc:qed:wpaper:1459
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    References listed on IDEAS

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    More about this item

    Keywords

    Optimal Contracts; Capital Structure; External Financing; Asymmetric Information; Information Transparency;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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