Debt- and Equity-Financed Investment: Equilibrium Structure and Efficiency Implications

Abstract

This paper considers the financing of investment in the presence of information asymmetry between 'insiders' and 'outsiders' of the firms. It establishes a well-defined capital structure for the economy as a whole with the following features: low-productivity firms rely on the equity market to finance investment at a relatively low level; mediumproductivity firms may not invest at all; and high-productivity firms rely on the debt market to finance investment at a relatively high level. It is shown that the debt market is efficient, with respect to the scope and the amount of investment made by each firm. However, the equity market fails: its scope is too narrow and the amount of investment each firm makes is too little. A unique but rather unconventional policy tool is proposed to achieve constrained Pareto-efficiency, i.e., subsidies to those firms that choose to equity-finance their investment (i.e., equity-marketcontingent grants).