Capital Structure under Heterogeneous Beliefs

We develop a dynamic structural model to examine the e¤ects of di¤ering beliefs of the manager and outsider investors regarding the pro…tability of a …rm’s projects and managershareholder agency con‡icts on its capital structure. The manager receives dynamic incentives through explicit contracts with shareholders whose implementation through …nancial 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 e¤ects of project characteristics on di¤erent components of capital structure: (i) Long-term debt declines with managerial optimism, while the manager’s inside equity stake and shortterm debt increase. (ii) Long-term debt and the manager’s inside equity stake decline with the …rm’s transient risk; the component of the …rm’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 …rm’s intrinsic risk— the component of the …rm’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 …rm’s expected future pro…tability. We calibrate our structural model to a sample of general …rms as well as a sample of IPO …rms, 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 …rms suggest that managers/entrepreneurs of IPO …rms are, indeed, signi…cantly more optimistic than general managers, and the degree of uncertainty about the pro…tability of IPO …rms is substantially higher. Overall, our …ndings show that imperfect information and asymmetric beliefs are important determinants of …rms’…nancial policies. JEL Classi…cation: G32