The optimal capital structure in a general equilibrium model of financial intermediation with asymmetric information

Finance

IFA Working Paper

1996

This paper studies the role of capital markets in an economy where entrepreneurs are endowed with opportunity of investment in a new project and with non-liquid wealth that can be used as collateral in financial contracts. A stock market is introduced to allow for direct borrowing and lending, and the question of financial disintermediation is dealt with under different assumptions on the information available to the stock market. Disintermediation results when intermediaries and lenders have symmetric information about entrepreneurs. When intermediaries have an informational advantage, entrepreneurs use capital structure to signal their types to potential buyers of stocks. It is shown that, depending on parameters of the model, both costless and costly equilibria are possible. In both equilibria the equilibrium debt-equity ratio is shown to be positively related to the value of collateral. In addition, the role of different market structures in the intermediation sector in determining equilibrium credit rationing and the extent of business activity is analysed. Changes in the distribution of the value of collateral have real effects on the level of business activity when entrepreneurs are constrained to finance new projects through the credit markets. With stock market as a financing alternative, equilibrium interest rate and the overall level of borrowing and lending may be unaffected by changes in the distribution of the value of collateral.

Institute of Finance and Accounting

FIN 247

IFA Working Paper

No