Capital Structure with Countervailing Incentives

Abstract

The regulated firm's choice of capital structure is affected by countervailing incentives: the firm wishes to signal high value to capital markets to boost its market value while also signaling high cost to regulators to induce rate increases. When the firm's investment is large, countervailing incentives lead both high- and low-cost firms to choose the same capital structure in equilibrium, thus decoupling capital structure from private information. When investment is small or medium-sized, the model may admit separating equilibria in which high-cost firms issue greater equity and low-cost firms rely more on debt financing.

JEL Classification: G31, G32, L51