Capital Structure and Quality of Service in Regulated Firms

Abstract

This paper analyzes the optimal choices of an entrepreneur who operates in a regulated sector, under uncertainty and asymmetric information. The entrepreneur chooses the firm’s capital structure and the provision of effort, while the regulator sets a price rule that establishes the firm’s revenue according to the quality of the service provided by the firm. The expected quality of the service is positively related to the entrepreneur’s exerted effort. This paper investigates how the firm’s capital structure and the level of effort provided by the entrepreneur vary according to the price rule. In particular, we show that an increase in the firm’s returns when the quality of the service is high, leads to an equilibrium with higher indebtedness and higher effort. On the contrary, an increase in the firm’s return when the quality of the service is low, induces ambiguous effects on debt and effort. Results can be interpreted as follows. Since indebtedness implies higher entrepreneur’s ownership, it is reasonable that the provision of effort and indebtedness move in the same direction. Such relationship clearly emerges when the regulator increases the returns for the provision of high quality service. However, as the payoff associated with the bad state of nature increases, the incentives to provide effort fall despite the convenience to increase the ownership share. These effects contrast each other and, then, the signs of the final changes are not obvious. Such results have important implications concerning the predictable effects of different price rules. In particular, it emerges that an increase in the price of the low quality service may induce higher effort by a change in the capital structure.