Working Paper: CEPR ID: DP9923
Authors: Roman Inderst; Vladimir Vladimirov
Abstract: In a dynamic model of optimal security design, we show when firms should preserve "equity capacity" through choosing high target leverage or "debt capacity" through choosing low target leverage. Thereby, firms reduce a problem of underinvestment or overinvestment when they must raise future financing under asymmetric information. Which problem arises depends on whether additional financing is raised at competitive terms or whether there is a lock-in with initial investors. Firms initial (or target) capital structure matters as it affects the "outside option" of both insiders and outside investors. Our theory also entails implications for start-up and venture capital financing.
Keywords: Asymmetric Information; Capital Structure; Dynamic Security Design; Venture Capital Financing
JEL Codes: G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| initial capital structure (G32) | outside options of insiders and outside investors (L24) |
| outside options of insiders and outside investors (L24) | investment efficiency (G14) |
| initial capital structure (G32) | investment efficiency (G31) |
| equity capacity preservation (G32) | underinvestment problem reduction (G31) |
| debt capacity preservation (G32) | overinvestment problem mitigation (G31) |
| bargaining power of investors (G24) | optimal security designs (F52) |
| initial financing decision (G31) | future capital structure (G32) |
| initial financing decision (G31) | investment efficiency (G14) |