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Capital structure and cost of capital when prices affect real investments

Minh T. Vo

Journal of Economics and Business, 2021, vol. 113, issue C

Abstract: This paper develops a theoretical model of financing with informational feedback effect that jointly determines a firm's capital structure and cost of capital. We show that under some conditions capital structure affects traders’ incentives to produce information about the prospect of the firm which they then use to trade in its securities. On one hand, informed trades incorporate new information into security prices which in turn help the firm make more efficient operating decisions. On the other hand, they increase the cost of capital as uninformed investors demand extra compensation in the form of a liquidity premium in anticipation that they will lose to informed traders. The optimal capital structure which maximizes the value of the firm is determined by the trade-off between high operating efficiency and low cost of capital. When information is not imperative for the firm's operating decisions, the Modigliani-Miller's irrelevance is maintained. However, when information is crucial for efficient operating decisions, the optimal capital structure is a balance between a high level of information revelation and a low cost of capital. The study can explain why many firms consistently hold low levels of debt and why firms with similar fundamentals may choose very different capital structures.

Keywords: Feedback effect; Capital structure; Cost of capital (search for similar items in EconPapers)
JEL-codes: G14 G30 G32 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1016/j.jeconbus.2020.105944

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