Debt issues and capital structure with soft information

Abstract

Purpose

The purpose of this paper is to investigate the role of “soft information” in firms’ debt issue and capital structure choices, and present a new model reconciling the gap between theories of capital structure and empirical findings.

Design/methodology/approach

The paper develops an analytical model of debt issues under asymmetric information in a setting where, in addition to observing the amount of debt the firm issues, outside investors obtain “soft information” signals through their own information production or noisy voluntary disclosures made by the firm. This paper analyzes the benefit and cost for the firm's debt issue decisions in this setting, and specifies the effect of soft information on these decisions.

Findings

If sufficiently precise soft information is available to outside investors, the firm's debt issue behavior is significantly altered relative to that in existing models. In particular, an inverted‐U shape relationship is found between the intrinsic value of the firm and the amount of debt it issues. Moreover, there is a negative relationship between the amount of debt the firm issues and the precision of soft information. Further, it is found that firms about which outside investors receive more favorable soft information issue less debt.

Research limitations/implications

The model predicts an inverted‐U shape relationship between firms’ debt ratios and operating performance. It also predicts that firms about which outside investors receive more favorable or more precise soft information have lower debt ratios on average. A rationale is provided for the existence of firms’ investor relations departments.

Originality/value

Firms’ capital structure choices remain a topic of significant importance. This paper incorporates the soft informations into firms’ debt issue decisions and proposes a new model of capital structure that generates insights into firms’ financing decisions and disclosure decisions, as well as information production by outside investors.

Citation

Jiao, Y. (2010), "Debt issues and capital structure with soft information", Managerial Finance, Vol. 36 No. 1, pp. 4-21. https://doi.org/10.1108/03074351011006810