Informational Efficiency and Liquidity Premium as the Determinants of Capital Structure

Posted: 8 Aug 2008

See all articles by Chun Chang

Chun Chang

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Xiaoyun Yu

Indiana University - Kelley School of Business - Department of Finance; China Academy of Financial Research (CAFR)

Multiple version iconThere are 2 versions of this paper

Date Written: August 5, 2008

Abstract

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.

Keywords: capital structure, information acquisition, security design, liquidity premium, under-leverage puzzle, corporate cash holdings

JEL Classification: D82, G32

Suggested Citation

Chang, Chun and Yu, Xiaoyun, Informational Efficiency and Liquidity Premium as the Determinants of Capital Structure (August 5, 2008). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1211524

Chun Chang

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Xiaoyun Yu (Contact Author)

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States
812-855-3521 (Phone)
812-855-5875 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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