Equilibrium Corporate Finance: Makowski meets Prescott and Townsend∗

We study a general equilibrium model with production where financial markets are incomplete. At a competitive equilibrium firms take their production and financial decisions so as to maximize their value. If firms form perfectly competitive conjectures, as shown by Makowski (1983a,b), shareholders unanimously support value maximization and competitive equilibria are constrained Pareto optimal. We extend this result to allow for intermediated short sales of firms’ equity and default. We also extend the analysis to encompass informational asymmetries. In this context we show that perfectly competitive conjectures implicitly support the equilibrium concept introduced by Prescott and Townsend (1984) and unanimity and constrained Pareto optimality are maintained. For all these economies the Modigliani-Miller theorem typically does not hold and the firms’ corporate financing structure is determinate in equilibrium.