Imperfect competition in financial markets and capital structure

Guriev, SG and Kvasov, D (2009) Imperfect competition in financial markets and capital structure. Journal of Economic Behavior and Organization, 72 (1). pp. 131-146. ISSN 0167-2681

Abstract

We consider a model of corporate finance with imperfectly competitive financial intermediaries. Firms can finance projects either via debt or via equity. Because of asymmetric information about firms’ growth opportunities, equity financing involves a dilution cost. Nevertheless, equity emerges in equilibrium whenever financial intermediaries have sufficient market power. In the latter case, best firms issue debt while the less profitable firms are equity-financed. We also show that strategic interaction between oligopolistic intermediaries results in multiple equilibria. If one intermediary chooses to buy more debt, the price of debt decreases, so the best equity-issuing firms switch from equity to debt financing. This in turn decreases average quality of equity-financed pool, so other intermediaries also shift towards more debt.