QED Working Paper Number

We propose a theory of optimal firm financing given nested information problems of adverse selection and agency cost. We prove that there exists a unique perfect Bayesian equilibrium with novel features: First, three types of optimal contracts arise endogenously, i.e., equity, transparent debt and opaque debt. Equity and transparent debt are both informational transparent because these contracts require firms to take on a costly technology for verifying types. Opaque debt, however, merely reflects the general information of firms seeking external funds. Any signaling contract that does not involve costly verification does not survive the equilibrium. Second, the equilibrium is either pooling on opaque debt, or mixing with transparent and opaque financing. Third, debt weakly dominates equity. Finally, the optimal debt-to-equity ratio is unique for all firms in a pooling equilibrium, but only for a strict subset of firms in a mixing equilibrium.

JEL Codes
Optimal Contracts
Capital Structure
External Financing
Asymmetric Information
Information Transparency
Working Paper