WP 2010-14 Capital Structure under Heterogeneous Beliefs

Published in 2014 in Review of Finance, Volume 18, Issue 5.

AUTHORS: Hae Won (Henny) Jung and Ajay Subramanian

ABSTRACT. We develop a dynamic structural model to examine the effects of differing beliefs of the manager and outsider investors regarding the profitability of a firm's projects and manager-shareholder agency conflicts on its capital structure. The manager receives dynamic incentives through explicit contracts with shareholders whose implementation through financial securities leads to a dynamic capital structure consisting of inside equity, outside equity, long-term debt and short-term debt. The analysis of the model generates novel testable implications for the effects of project characteristics on different components of capital structure: (i) Long-term debt declines with managerial optimism, while the manager's inside equity stake and short-term debt increase. (ii) Long-term debt and the manager's inside equity stake decline with the firm's transient risk; the component of the firm's risk that is resolved over time due to Bayesian learning. Short-term debt, however, increases with the transient risk. (iii) Long-term debt increases with the firm's intrinsic risk - the component of the firm's risk that is invariant through time - while short-term debt and the manager's inside equity stake decline. (iv) Longterm and short-term debt increase with the firm's expected future profitability. We calibrate our structural model to a sample of general firms as well as a sample of IPO firms, and show the quantitative impact of asymmetric beliefs on capital structure. Without making any assumptions about their relative magnitudes at the outset, the calibrated parameter values corresponding to the two sets of firms suggest that managers/entrepreneurs of IPO firms are, indeed, significantly more optimistic than general managers, and the degree of uncertainty about the profitability of IPO firms is substantially higher. Overall, our findings show that imperfect information and asymmetric beliefs are important determinants of firms' financial policies.