Academic journal article Journal of Money, Credit & Banking

Asymmetric Information, Repeated Lending, and Capital Structure

Academic journal article Journal of Money, Credit & Banking

Asymmetric Information, Repeated Lending, and Capital Structure

Article excerpt

THE FIRM'S CHOICE OF CAPITAL STRUCTURE has interested economists for a long time. Modigliani and Miller (1958) showed that in the absence of taxes or information problems, the choice of capital structure was irrelevant to the value of the firm. Jensen and Meckling (1976) showed that the optimal capital structure depends critically on the information structure. Townsend (1979) and Gale and Hellwig (1985) showed that asymmetric information regarding the value of output produced by the firm leads to the emergence of debt financing; debt is optimal because it minimizes the observations costs arising in the environment of asymmetric information.

This paper extends Townsend and Gale and Hellwig by showing that retained earnings will be an important part of the capital structure in the presence of the ex post information asymmetry. The firm will retain earnings in order to achieve more favorable credit terms. Retained earnings improve credit terms because the retained earnings serve as a buffer to protect lenders from the risk of default, and competition in the credit market causes this benefit to be passed back to the borrower.

In Boot, Thakor, and Udell (1991) firms use collateral to obtain more favorable loan terms. In their paper, collateral ameliorates costs associated with asymmetric information. Their approach differs from the approach in this paper in that the availability of collateral is exogenously determined in their paper, whereas the availability of earnings to retain is endogenous in this paper. Thus, this paper examines the effect of a firm's current profitability on its capital structure, and the propagation of real shocks through financial market effects.

In this model, a firm's earnings today will influence its credit terms tomorrow. If an adverse shock hits the firm today, then its retained earnings will be reduced, which will cause the firm either to face a higher interest rate and a higher probability of default in the subsequent period, or to be denied credit entirely and thus be unable to operate. Therefore, at the macroeconomic level, if a real shock adversely affects the distribution of output today, then retained earnings will fall, causing those firms that are able to obtain credit to face less favorable loan terms, which will increase their probability of default in the following period. Also, the reduction in retained earnings may lead to some firms being denied credit entirely, that is, the reduction in retained earnings increases the probability of credit rationing. Thus, temporary disturbances to real activity may be propagated over time through the effects of retained earnings on credit terms.

In Bernanke and Gertler (1989) borrower net worth influences output dynamics. In thier paper, net worth influences the cost of outside finance, which in turn influences the borrower's decision about whether to operate his project or to place his savings in a storage technology. In this paper, borrowers will always want to operate their projects, but low retained earnings may lead to credit rationing.

Williamson (1986) also develops a model in which financial market effects can propagate real shocks. His analysis differs from the analysis here in that the firms in his model are financed only through outside debt; there are no retained earnings in his model. This leads to a difference in the incidence of credit rationing; in his model, firms that are costly to observe are rationed, whereas in this model, firms with low retained earnings are rationed.

A number of recent papers have examined the empirical link between a firm's investment and the firm's financial condition. Whited (1992) incorporated a constraint on a firm's ability to issue debt into a model of investment, and found that including the financial constraint resulted in a significant improvement in the Euler equation's ability to explain investment behavior, particularly for firms that did not have access to the corporate bond market, and for firms that have a high ratio of debt to assets. …

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