Imperfect Competition in Financial Markets and Capital Structure

Abstract:     
We consider a model of corporate finance with imperfectly competitive financial intermediaries. Firms can finance projects either via debt or via equity. Because of asymmetric information about firms' growth opportunities, equity financing involves a dilution cost. Nevertheless, equity emerges in equilibrium whenever financial intermediaries have sufficient market power. In the latter case, best firms issue debt while the less profitable firms are equity-financed. We also show that strategic interaction between oligopolistic intermediaries results in multiple equilibria. If one intermediary chooses to buy more debt, the price of debt decreases, so the best equity-issuing firms switch from equity to debt financing. This in turn decreases average quality of equity-financed pool, so other intermediaries also shift towards more debt.

Number of Pages in PDF File: 35

Keywords: Capital structure, pecking order theory of finance, oligopoly in financial markets, second degree price discrimination

JEL Classification: D43, G32, L13

working papers series