Debt Issues and Capital Structure with Soft Information: A Theoretical Analysis

Abstract

We develop a model of debt issues under asymmetric in a setting where, in addition to observing the amount of new debt the firm issues in a certain period of time, outsiders obtain information signals about firms through noisy voluntary disclosures made by firms or production by outsiders. We show that, if sufficiently precise soft is available to outsiders, firms' debt issue behavior is significantly altered in equilibrium relative to that in existing models (e.g., Ross, 1977). In particular, while Ross (1977) predicts that higher intrinsic value firms will issue more debt than lower intrinsic value firms, our model predicts an inverted-U shape relationship between the intrinsic value of a firm and the amount of new debt it issues in a certain period of time. Moreover, we predict that firms about which outsiders receive more favorable soft will on average issue less new debt compared to firms about which outsiders receive less favorable soft information. We also predict that, while on average the announcement effect to public debt issues in a certain period of time is zero, the announcement effect to a new public debt issue will be positive or negative depending on the realization of outsiders' soft about this firm: firms about which outsiders have more favorable soft will receive algebraically larger (more positive or less negative) announcement effects to their new debt issues. Further, we have predictions for the relationship between the precision of outsiders' soft and the amount of new debt that firm issues, and for a firm's debt to equity ratio. Finally our model provides a rationale for the existence of investor relations departments in many firms.