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Debt and Outside Equity as Information Revelation Mechanisms

Posted: 15 Oct 1998  

Michel A. Habib

University of Zurich; Swiss Finance Institute

D. Bruce Johnsen

George Mason University - School of Law; PERC - Property and Environment Research Center

Date Written: August 1998

Abstract

This paper presents a unified theory of debt and outside equity based on specialized valuation of the corporate enterprise. We model the decision of an entrepreneur to use debt and equity finance to get credible information from different specialists about the value of the enterprise in various uses across alternative states of the world. The equity valuation specialist -- who could be a venture capitalist or another type of equity partner -- provides a price forecast for equity that reveals demand-side information about the value of the enterprise in the good sates. His equity share represents a claim on the cash flow generated by the enterprise in its primary use. The debt valuation specialist provides a price forecast for debt that reveals information about the value of the enterprise in the bad states. His loan represents a claim on the cash flow generated by the enterprise if redeployed to its next best use. The prices forecast for debt and equity by the valuation specialists credibly reveal their private information because the entrepreneur requires them to buy the associated claim at the forecast price, thereby bonding their valuations. In contrast to recent work on the role of debt and outside equity in communicating supply-side information to outside investors, we focus on the communication of demand-side information to the entrepreneur. We provide testable implications that conflict with those provided by accepted informational explanations for debt and outside inquiry.

JEL Classification: G31, G32

Suggested Citation

Habib, Michel A. and Johnsen, D. Bruce, Debt and Outside Equity as Information Revelation Mechanisms (August 1998). Available at SSRN: https://ssrn.com/abstract=131688

Michel A. Habib

University of Zurich ( email )

Plattenstrasse 14
Zurich, 8032
Switzerland
41-44-634-2507 (Phone)
41-44-634-4903 (Fax)

HOME PAGE: http://www.isb.uzh.ch/institut/profs/mhabib.htm

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

D. Bruce Johnsen (Contact Author)

George Mason University - School of Law ( email )

3301 Fairfax Drive
Arlington, VA 22201
United States
703-993-8066 (Phone)
703-993-8088 (Fax)

PERC - Property and Environment Research Center

2048 Analysis Drive
Suite A
Bozeman, MT 59718
United States

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