Informational Efficiency and Liquidity Premium as the Determinants of Capital Structure
Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)
Indiana University - Department of Finance; China Academy of Financial Research (CAFR)
May 21, 2008
14th Annual Conference on Financial Economics and Accounting
Journal of Financial and Quantitative Analysis (JFQA), Forthcoming
This paper investigates how a firm's capital structure choice affects the informational efficiency of its security prices in the secondary markets. We identify two new determinants of a firm's capital structure policy: liquidity (adverse selection) premium due to investors' anticipated losses to informed trading, and operating efficiency improvement due to information revelation from the firm's security prices. We show that capital structure decision affects traders' incentives to acquire information and subsequently, the distribution of informed traders across debt and equity claims. When information is less imperative for improving its operating decisions, a firm issues zero or negative debt (i.e., holding excess cash reserves) in order to reduce socially wasteful information acquisition and the liquidity premium associated with it. When information is crucial for a firm's operating decisions, the optimal debt level is one which achieves maximum information revelation at the lowest possible liquidity cost. Our model can explain why many firms consistently hold no debt. It also provides new implications for financial system design and for the relationship among leverage, liquidity premium, profitability, and the cost of information acquisition.
Number of Pages in PDF File: 58
Keywords: capital structure, security design, allocative information, liquidity premium, under-leverage puzzle, corporate cash holdings
JEL Classification: D82, G32Accepted Paper Series
Date posted: January 27, 2004 ; Last revised: September 8, 2009
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