Information Spillovers and Capital Structure

This paper studies the role of information spillovers across securities of a firm on the overall financing costs and security choice. I model the capital structure choice of firms in a dynamic setting and study the intertemporal patterns in security issuance. The model examines the interaction among information production technologies of different securities and the impact of information spillovers from public securities on the capital structure and long run financing costs of a firm. In the model, I show that firms use bank borrowing initially to minimize the lemons cost. Subsequently, when they meet the feasibility conditions for sustaining a market for their securities, they issue public equity (IPO) and then use either bank borrowing or bonds for subsequent financing rounds. This sequence of securities is optimally chosen to maximize the gains from information spillovers from public equity. Firms trade off the initial lemons cost of issuing information sensitive public equity against the gains from having more informative stock prices arising from endogenous information production in financial markets. The information spillover gains occur through a reduction in (i) bank monitoring costs and (ii) adverse selection costs of future financing. This effect has implications for the sequencing of securities over the life of the firm, and in particular the decision to go public.