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Informational Efficiency and Liquidity Premium as the Determinants of Capital Structure

Published online by Cambridge University Press:  19 February 2010

Chun Chang  and
Xiaoyun Yu
Chun Chang
Affiliation:
China Europe International Business School, 699 Hongfeng Road, Pudong, Shanghai 201206, China. cchun@ceibs.edu
Xiaoyun Yu
Affiliation:
Kelley School of Business, Indiana University, 1309 E. 10th St., Bloomington, IN 47405. xiyu@indiana.edu
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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: the 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 the 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 that 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.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 2 , April 2010 , pp. 401 - 440
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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