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

Author

Listed:
  • Assaf Razin
  • Efraim Sadka
  • Chi-Wa Yuen

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; medium-productivity 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 investmentmade 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-market-contingent grants).

Suggested Citation

  • Assaf Razin & Efraim Sadka & Chi-Wa Yuen, 2001. "Debt- and Equity-Financed Investment: Equilibrium Structure and Efficiency Implications," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 57(4), pages 361-375, August.
    • Handle: RePEc:mhr:finarc:urn:sici:0015-2218(200108)57:4_361:daeies_2.0.tx_2-i
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    Citations

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    Cited by:

    1. Mr. Philip R. Lane & Mr. Gian M Milesi-Ferretti, 2000. "External Capital Structure: Theory and Evidence," IMF Working Papers 2000/152, International Monetary Fund.
    2. Faria, Andr & Mauro, Paolo, 2009. "Institutions and the external capital structure of countries," Journal of International Money and Finance, Elsevier, vol. 28(3), pages 367-391, April.

    More about this item

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation

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