Optimal Capital Structure with Stock Market Feedback
Caio Machado, Ana Elisa Pereira
Review of Finance, Volume 27, Issue 4, July 2023, Pages 1329–1371, https://doi.org/10.1093/rof/rfac056
By aggregating the views of many investors, asset prices convey information that guides firm managers in their investment decisions. This forms the basis of a feedback effect whereby prices not only reflect but also affect investment decisions—a phenomenon that has been studied in the recent literature. Trading frictions, however, may impede the incorporation of speculators’ information into prices, limiting the gains in real efficiency created by stock markets. In our paper, we study how firms can adjust their capital structure to overcome such a detrimental effect of frictions.
We start from a model that builds on Dow, Goldstein and Guembel (2017). The manager of a publicly traded firm has imprecise information about the profitability of an investment opportunity and can observe stock prices before deciding on investment. Speculators receive private signals about the investment profitability before trading the firm’s stocks. The equilibrium in that market often features an inefficiently low level of informativeness: frictions, such as trading costs, limit the incorporation of speculators’ information into prices. We show that equilibrium outcomes in the financial market depend crucially on the firm’s capital structure, and study how the firm can optimally issue debt and equity in an initial stage.
When setting its capital structure, the firm considers the impact it will have on speculators’ incentives to trade stocks and on the manager’s incentives to invest, which are intertwined. Debt issuance affects speculators’ trading incentives both directly, by changing the payoff structure of equity holders, and indirectly, through an asset substitution effect—higher debt increases managerial risk taking, rendering the information traders have about the risky investment opportunity more valuable. The latter effect is only present if debt is risky, in which case, when choosing its capital structure, the firm faces a trade-off between obtaining more information from the market and using information more efficiently.
We show that, by issuing enough debt, firms can increase market informativeness and firm value, and may eliminate a coordination failure equilibrium with no provision of market information. Risky debt is often optimal, even though it distorts managerial incentives. This is because, once one takes into account that firms’ information set is affected by their capital structure, risky debt does not necessarily lead to risk shifting. Since more risk taking encourages information production in financial markets, risky debt may end up improving managerial decisions. In short, precisely because risky debt gives the “wrong” incentives for managers, it gives the “right” incentives for speculators to trade the firms’ stocks.
By studying the interplay between secondary financial markets and firms’ liabilities, the model yields empirical predictions regarding the relationship between firms’ capital structure, financial market frictions, and market informativeness.