Relevance or Irrelevance of Capital Structure

In this paper we examine the effects of asymmetric information on the nature of financial equilibrium and on the capital structure of firms. In the first model presented, the financial contracts on offer involve pooling equilibrium with no adverse selection. However, in the special case analyzed, where contracts are of mixed form, there may be a separating equilibrium and also equilibrium may not exist. Interesting result is that the separating equilibrium found is not economically efficient since aggregate investments falls short of first-best level. More importantly, capital structure does matter. The relative magnitude of outside equity makes a real difference to the quantity of aggregate investment in equilibrium.