Optimal Leverage, Profitability and the Decision to Go Public

Abstract

I consider the role of firm transparency in shaping its capital structure. In a costly-state-verification model, the optimal capital structure can be implemented by a mixture of debt and outside equity. Consistent with empirical evidence, leverage decreases with both past and expected profitability, unlike in static trade-off theories. Highly profitable firms optimally choose zero leverage and finance themselves with equity. If firms can increase their transparency at a cost – say by going public – they tend to do so when interest rates are lower, when they face larger financing needs, when bankruptcy costs are higher and when analysts generate better information.

Keywords: optimal leverage and profitability, costly-state-verification, Ini- tial Public Offerings (IPOs), asymmetric information, trade-off theories, capital structure, transparency, security design

JEL Classification: D82, G20, G30