RISK-SHARING AS A DETERMINANT OF CAPITAL STRUCTURE: INTERNAL FINANCING, DEBT, AND (OUTSIDE) EQUITY

Yadira González de Lara (yadira@merlin.fae.ua.es)
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Yadira González de Lara: Universidad de Alicante

Working Papers. Serie AD from Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie)

Abstract: This paper proposes a historically-grounded mechanism-design model of corporate finance, with two-side risk aversion under limited contract enforceability, where (inside) equity held by entrepreneurs, debt and (outside) equity coexist. This capital structure shares optimally the non-diversifiable risk associated with costly and risky ventures. Furthermore, it uniquely sustains the optimal risk allocation if agents' personal wealth is contractible at a higher enforcement cost than the projects' returns. Otherwise, the irrelevance theorem of Modigliani and Miller applies. Consistent with the theoretical predictions, we observe that (i) risk-averse merchants-entrepreneurs financed part of their ventures (hold inside equity) and raised additional funds from risk-averse investors through debt-like sea loan and equity-like commenda contracts when long-distance medieval trade was indeed highly costly and risky and that (ii) maritime insurance, with higher protection against the non-diversifiable "risk of loss at sea or from the action of men" but higher enforcement costs, did not develop until the mid-fourteenth century, when the ventures' costs and risk had decreased significantly. Whereas the model emphasizes the entrepreneurs' equity holdings and the limited-liability aspects of debt and equity, the choice between debt or equity derives from simple, although historically backed, information assumptions. The analysis is therefore complementary to other capital-structure theories based on agency costs, information asymmetries, signalling, transaction costs and incomplete contracting.

Keywords: debt contracts; capital structure; creditworthiness; enforceability; inside and outside equity; insurance; limited liability; private information; risk-sharing (search for similar items in EconPapers)
JEL-codes: D81 D82 G22 G32 N23 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2004-04
New Economics Papers: this item is included in nep-bec, nep-cfn, nep-fin, nep-fmk and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:ivi:wpasad:2004-16

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