Journal of Economics and Business xxx (xxxx) xxx

Contents lists available at ScienceDirect

Journal of Economics and Business

journal homepage: www.elsevier.com/locate/jeb

Capital structure and cost of capital when prices affect

real investments
Minh T. Vo 1
College of Management, Metropolitan State University, 1501 Hennepin Avenue, Minneapolis, MN 55403, USA

A R T I C L E I N F O A B S T R A C T

JEL classification: This paper develops a theoretical model of financing with informational feedback effect that
G14 jointly determines a firm’s capital structure and cost of capital. We show that under some con­
G30 ditions capital structure affects traders’ incentives to produce information about the prospect of
G32
the firm which they then use to trade in its securities. On one hand, informed trades incorporate
Keywords: new information into security prices which in turn help the firm make more efficient operating
Feedback effect
decisions. On the other hand, they increase the cost of capital as uninformed investors demand
Capital structure
extra compensation in the form of a liquidity premium in anticipation that they will lose to
Cost of capital
informed traders. The optimal capital structure which maximizes the value of the firm is deter­
mined by the trade-off between high operating efficiency and low cost of capital. When infor­
mation is not imperative for the firm’s operating decisions, the Modigliani-Miller’s irrelevance is
maintained. However, when information is crucial for efficient operating decisions, the optimal
capital structure is a balance between a high level of information revelation and a low cost of
capital. The study can explain why many firms consistently hold low levels of debt and why firms
with similar fundamentals may choose very different capital structures.

1. Introduction

Financial markets play an important role in the economy. They are places where investors trade to profit from their information. In
the trading process security prices aggregate all information from various sources and provide information that would be hard to
generate otherwise. At least since Hayek (1945) financial economists have known that prices play an allocational role as they convey
important information that can improve the efficiency of real investment decisions. Although, as insiders, managers know a great deal
about their own firms, to make good operation decisions they also need something else, for instance, information about consumers,
suppliers, other firms in the industry, other industries, etc. Such information is dispersed among many agents in the economy and can
only be aggregated efficiently via trades in financial markets. Security prices thus contain useful information that can help firms make
efficient operation decisions. This is known as a feedback effect - prices not only reflect the cash flows generated by firms but also affect

E-mail address: minh.vo@metrostate.edu.

1
I thank Kenneth Kopecky, Wilson Tong, two anonymous referees, Allen Bellas, and seminar participants at the Midwest Finance Association
Conference in Chicago (2019), the Western Economic Association International Conference in San Diego (2017) for helpful comments. Remaining
errors are my responsibility.

https://doi.org/10.1016/j.jeconbus.2020.105944
Received 15 April 2020; Received in revised form 21 August 2020; Accepted 2 September 2020
Available online 22 September 2020
0148-6195/© 2020 Elsevier Inc. All rights reserved.

Please cite this article as: Minh T. Vo, Journal of Economics and Business, https://doi.org/10.1016/j.jeconbus.2020.105944
M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

them. Bond, Edman, and Goldstein (2012) provide thorough survey on feedback effect literature.
This paper investigates whether a firm can use its capital structure to maximize the informational efficiency2 in its real investment
decisions. More specifically, we attempt to answer the following research questions: (i) whether and to what extent a firm can use
leverage to benefit from information production in financial market; (ii) whether there exists an optimal capital structure which
maximizes the value of the firm; (iii) why firms with similar fundamentals could have very different capital structures. Toward these
ends, we develop a model of financing with informational feedback effect that jointly determines a firm’s capital structure and cost of
capital. Our model features a firm facing a choice between a risky high growth strategy and a riskless conservative strategy, and issuing
debt and equity in primary markets to finance its business. The securities are then traded in secondary markets among uninformed
investors who have liquidity needs and a speculator who can obtain costly information about the firm’s profitability to trade for profit.
The speculator chooses the optimal amount of information to produce to maximize profit. Trading causes some speculator’s infor­
mation to be incorporated into security prices. The firm then extracts information from prices for its operation decisions. The market
makers set efficient security prices taking into account the fact that their prices will affect the firm’s operations and therefore its cash
flows. Thus, security prices both reflect and affect the firm’s fundamentals - the so-called feedback effect. We show that when the firm
has complete information or when information is not imperative for its decision making, the Modigliani-Miller’s irrelevance is
maintained. In this case, the speculator does not acquire costly information since he cannot benefit from it. The cost of capital is thus
zero and there is no feedback effect. When information extracted from security prices is crucial for the firm to make efficient operation
decisions, the feedback effect does exist. If the firm issues no bond or riskless bond its value is independent of capital structure.
Although the firm still benefits from the feedback effect, it has no control over information production and cost of capital. However, if
the firm issues risky bonds, capital structure does matter and there exists an optimal level of leverage which maximizes the value of the
firm. Information produced in the market is negatively related to the leverage level. On one hand, when traders produce more in­
formation, they make security prices more informative which help the firm make efficient operation decisions. On the other hand, they
increase the cost of capital as uninformed investors demand extra compensation in the form of a liquidity premium in anticipation that
they will lose to informed traders. The optimal capital structure trades off the two effects on the firm’s value. Our model predicts that
under some conditions, high growth firms tend to use less debt than more established ones. Firms with similar fundamentals but
different in information need can have very different capital structures.
The study features a game theoretic model in which the speculator takes the firm’s leverage as given and chooses the amount of
costly information to produce to maximize his trading profit. Under some conditions, his information production is a function of the
leverage. The firm then takes the speculator’s information as given and chooses its capital structure to maximize its own value. In
equilibrium, the information produced by the speculator is positively related to the market liquidity but negatively related to the level
of debt. Intuitively, if the market is more liquid, the speculator can trade higher volumes without being detected and therefore get
higher profit. He, thus, increases his information production. In addition, since equity is more information sensitive than debt, the
speculator can benefit more when the firm issues more equity (less debt). Hence, he produces more information when the firm uses less
debt. The cost of capital rises with the speculator’s profit and therefore with his information production. The optimal level of debt is
increasing in the market liquidity and decreasing in the risk of the high growth strategy. Intuitively, when the market is highly liquid,
the speculator increases his information acquisition and reveals more useful information via trades which helps the firm make efficient
operation decisions. However, this also raises the firm’s cost of capital since it is the profit of the speculator. To balance the two
opposite effects, the firm needs to raise debt level. Other things equal, as the risk of the high growth strategy increases, the firm needs
more information from the speculator to make efficient decisions and therefore it reduces debt. Thus, the model can explain why many
firms consistently hold low levels of debt.
The literature on capital structure is vast. Modigliani and Miller (1958) state that in perfect markets capital structure does not
matter: firms with the same future cash flow distribution will have the same market value regardless of their financing methods. This
result rarely holds in practice as markets are not perfect. Frictions have been added to the standard theory to establish an interior
financing optimum. The trade-off theory argues that capital structure is determined by a trade-off between the benefits of debt and the
costs of debt. Most corporate finance textbooks mention the tax-bankruptcy trade-off: firms balance the tax benefits of debt and the
bankruptcy costs. In our model, it is the trade-off between high operating efficiency and low cost of capital in the form of liquidity
premium. In models based on agency costs, initiated by Jensen and Meckling (1976), debt lessens the agency problem of free cash flow
as it must be repaid or the firm goes bankrupt; this makes managers more careful in spending cash.
Myers (1984) proposes the pecking order theory in which there are three main sources of funding available to the firm: equity, debt
and retained earnings. Equity has the most serious adverse selection problem, retained earnings have none while debt is somewhere in
between. Thus, firms would use retained earnings when possible. If retained earnings are not adequate, they issue debt and equity is
the last resort. The market timing theory argues that firms’ financing decisions depend on the conditions of debt and equity markets. If
they need funds, they use the more favorable market. If neither is favorable, they may postpone the issuance. Consistent with this
theory, in Graham and Harvey (2001) firms tend to issue equity following a stock run-up.
However, researchers report that in reality firms choose capital structures that differ from the theoretically optimal ones. For
instance, Graham (2000) shows that firms are very conservative in using leverage. Furthermore, firms with similar fundamentals may
choose very different capital structures. Recently, financial economists have tried a behavioral finance approach to explain how firms

2
A market is informationally efficient if all available information pertaining to a firm has been incorporated into its current security prices. In the
context of the paper, a firm can use its capital structure to influence the amount of information produced in the market which is then incorporated
into its stock and bond prices via trades in the secondary markets.

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M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

choose their capital structure. Malmendier, Tate, and Yan (2011) and Cronqvist, Makhija, and Yonker (2012) suggest that leverage
decisions are related to the personal characteristics of firms’ CEOs. Hackbarth (2008, 2009) use models with managerial traits to show
that optimistic and/or overconfident managers may employ leverage aggressively and need not follow a pecking order.
Feedback effect has been studied in literature. On the empirical side, Chen, Goldstein, and Jiang (2007) provide evidence that that
managers learn new information from stock prices and incorporate it into corporate investment decisions. Luo (2005) shows that
merging companies tend to extract information from market reactions and take it into account when they close deals. Baker, Stein, and
Wurgler (2003) demonstrate that stock prices have a stronger impact on the investments of firms that rely on external equity to finance
their marginal investments. Edmans, Goldstein, and Jiang (2012) show that financial markets have real effects by affecting the
behavior of managers. On the theory side, financial economists incorporate feedback effects into models of financial markets to better
understand the price formation process and its implications for the real economy. This includes Bond, Goldstein, and Prescott (2010),
Chang and Yu (2004, 2010), Dow and Rahi (2003), Foucault and Gehrig (2008), Fulghieri and Lukin (2001), Goldstein and Guembel
(2008), Subrahmanyam and Titman (1999), to name just a few.
Related to our paper, Chang and Yu (2010) also investigate how, in the presence of feedback effect, a firm’s capital structure choice
affects the informational efficiency of its security prices. The main difference between Chang and Yu (2010) and ours lies in the ef­
ficiency of the bond market. In ours, information is incorporated into stock and bond instantly and both prices are equally efficient. In
Chang and Yu (2010), while the stock price is always set efficiently, the bond price is not because the bond market maker is not able to
use information from the stock market to set the bond price. This does not reflect well the reality. In fact, using intraday data, Hotchkiss
and Ronen (2002) find that the informational efficiency of corporate bonds is similar to that of the underlying stocks and stocks do not
lead bonds in reflecting firm-specific information. Furthermore, information is incorporated into both stock and bond prices at the
same speed. As a result of the inefficient bond market, their findings differ from ours in several ways. First, Chang and Yu (2010) argue
that when the firm has complete information, it must use zero or even negative debt to deter traders from acquire information to trade.
In contrast, in efficient markets, we show that the Modigliani-Miller’s irrelevance holds and there is no feedback effect. Second, while
in our paper the firm can learn from both stock and bond prices for its operating decision, in Chang and Yu (2010), it only learns from
the stock price because the bond price is inefficient. Third, in Chang and Yu (2010), the firm issues not-too-risky debt to keep informed
traders from trading in the bond market and thus in equilibrium, informed trades only take place in the stock market. In contrast, our
model indicates that the firm can issue all types of debts, from zero to risky. However, only issuing risky debt can it influence the
amount of information produced in the market to achieve the optimal trade off between operating efficiency and cost of capital.
Furthermore, informed trades occur in both stock and bond markets.
The remainder of the paper is organized as follows. In Section 2 we describe the model, derive the equilibrium and discuss the
optimal information acquisition of the speculator. In Section 3, we derive the optimal capital structure and discuss the implications.
Section 4 concludes the paper.

2. The model

2.1. The economic setting

There are four dates. Market participants include a firm (a manager), a speculator, a bond market maker, a stock market maker, and
a number of liquidity traders in stock and bond markets. All of them are risk neutral. The interest rate is normalized to zero. At date 0,
the manager chooses capital structure (the face value of the debt) F to maximize the value of the firm and then issues stocks and bonds
to raise capital. We assume that the market makers and the speculator do not participate in the primary markets.3 At date 1, the
speculator acquires information about the firm and trades take place in the stock and bond secondary markets. At date 2, after
observing security prices, the manager makes an operation decision. At date 3, cash flows are realized and security holders are paid
accordingly. The time line is summarized in Fig. 1. In the following, we will provide more information about each market participant.

The firm
The firm owns a production technology which converts capital stochastically into cash flow θ̃ at date 3. The value of the firm
depends on the operation decision the manager makes at date 2. For simplicity, we assume that the manager chooses either conser­
vative or growth investment strategy. The conservative strategy is riskless and yields a certain cash flow of θ̃c = M. The growth
strategy, on the other hand, is risky. Its cash flow θ̃g is a function of a random variable μ̃ which takes two values, H or L, with equal
probability. More specifically,

3
This is a common assumption in literature to induce cost of capital. Since the market makers and the speculator are risk neutral and do not
experience liquidity shocks, their participations in the primary markets would drive out liquidity traders and therefore eliminate the cost of capital.

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M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

Fig. 1. The timeline.

{
m + e if μ̃ = H
θ̃g = ,
m − e if μ̃ = L

where m > M > m − e. Thus, the growth strategy yields higher expected cash flow. Given the firm’s risk neutrality, the manager only
chooses the conservative strategy when he knows μ̃ = L with high enough probability.4 The term e can be considered as the payoff
volatility (or risk) of the growth strategy. The level of debt F is assumed to be smaller than M. Thus, the debt is riskless if the manager
chooses the conservative strategy. At date 1, the manager learns a signal x at no cost which reveals μ̃ perfectly with probability f and is
uninformative with probability 1 − f. In this setting, f measures the quality of the firm’s information.

The speculator
The speculator is able to acquire costly information to trade for profit. Thus, his problem is to choose the amount of information to
maximize expected profits. At date 1, he expends resources to acquire signal y ∈ {h, l} such that
1+α
prob(μ̃ = H|y = h) = prob(μ̃ = L|y = l) = ,
2

where α ∈ [0, 1] at the cost C(α) = 12 cα2 , where we assume that c > 3e/16. This assumption is to avoid corner solutions for the optimal
information acquisition. Thus, the more resources he spends, the higher quality is his signal. However, the cost of the signal increases at
a faster rate than its precision.

Market makers
The market makers observe aggregate order flows without knowing which order comes from which trader. They then set
competitive prices to break even as in Kyle (1985). Since there is informational feedback effect from markets to the firm, the market
makers take into account the impact of their pricing on the manager’s action which, in turn, affects the value of the firm and vice versa.
In other words, prices both reflect and affect the value of the firm. Both the bond market maker and the stock market maker are allowed
to communicate with each other when setting prices in their markets. This assumption implies information can be incorporated into
stock and bond prices at the same rate which is consistent with the reality. In fact, using intraday data, Hotchkiss and Ronen (2002)
show that information is reflected in both stock and bond at the same time and both prices are equally informative.

Liquidity traders
Liquidity traders buy or sell securities for reasons exogenous to the model. At date 0, those investors buy the firm’s securities. At
date 1, they experience liquidity shocks and have to trade. The aggregate shares of liquidity trades in the stock (bond) market are
denoted by nS (nB ) which takes values of σS (σ B ) or − σS (− σB) with equal probability. Thus, σS (σ B) represents both the volatility of the
liquidity trades and the stock (bond) market depth. In practice, the stock market is deeper and more volatile than the bond market;
therefore, we assume that σS > σB and σ s − σB is approximately stable. To avoid discussing corner solutions for optimal capital structure

4
Let p be the probability that μ̃ = L. The manager chooses the conservative strategy iff
m+e− M
p(m − e) + (1 − p)(m + e) < M ⇒ p > .
2e

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in Proposition 5, we further assume that [3 − 2(σS + σB ) ]/[2(σ S − σB ) ]〈1.

A fixed point problem arises due to feedback effect. In setting security prices, the market makers forecast not only μ̃ but also the
manager’s belief about μ̃ (via stock and bond prices) since it will affect the value of the firm through his action. In general, there is no
closed-form solution for this fix-point problem. The assumption of binary liquidity trades helps us overcome this issue and obtain a
closed-form solution for the problem.
The information structure is summarized in Table 1. In cases 1 and 2, the firm has complete information, the speculator neither
trades nor acquires information as he cannot make profits, so his information is ∅. Later, we will show in Proposition 1 that the firm’s
information is fully reflected in security prices. In other words, the markets are of strong-form efficiency.
In case 3, the firm has no information and relies solely on the market prices to make operation decisions. Thus, the speculator has
incentive to acquire information to trade. In the presence of the feedback effect, the market makers set efficient prices based on two
factors:

1. The aggregate order flows in the markets, which contain the speculator’s information y; and
2. The firm’s response after observing the market prices, which depends on its belief about the information content of the prices.

Let μ̃ be the information about the firm in the economy and let B(μ̃) be the firm’s belief about μ̃ after observing the market prices. In
case 3, μ̃ = y. The market makers’ pricing rule is:
P = P[μ̃, B(μ̃) ] = P[y, B(y) ].

Market equilibrium, therefore, requires y = B(y) and so we can write P = P(y). In other words, the markets are also strong-form
efficient as in cases 1 and 2. In fact, the resulting strong-form market efficiency in the model is a consequence of the feedback ef­
fect, in which the market makers forecast not only the information about the firm, μ̃, but also the firm’s belief about μ̃. In equilibrium
these two projections are identical.

2.2. The equilibrium

We employ the notion of Bayesian–Nash equilibrium in this paper.

Definition. A Bayesian–Nash equilibrium of the trading-investment game consists of (i) the firm’s strategies on capital structure
and investment, and belief given the market prices and its information, (ii) the speculator’s trading strategies in the bond and equity
markets, (iii) the market makers’ pricing rules and their beliefs given order flows, i.e. the posterior distribution of the firm’s value
given the aggregate order flows, such that:

1. The firm maximizes its value at date 0;

2. The speculator maximizes his expected profit;
3. The market makers set efficient security prices and break even;
4. The beliefs are consistent with Bayes’ rule wherever applicable.

We use the backward induction approach to derive the equilibriums. We will separately examine equilibriums when the firm has
complete information (cases 1 and 2) and when it has no information at all (case 3). Subscripts S and B will be used to denote stock and
bond, respectively.

2.2.1. Equilibrium when the firm has complete information

Let P0B ( ⋅ ), P0S ( ⋅ ), π ( ⋅ ), and V0 ( ⋅ ) be the bond and stock prices, the cost of capital, and the value of the firm, respectively, at time
0. Since the manager knows the realization of μ̃, he uses it to maximize the terminal cash flow. In particular, he chooses the growth
strategy if μ̃ = H and the conservative strategy if μ̃ = L. Thus, the bond is riskless and so P0B (H) = P0B (L) = F. Given his investment
strategy, the terminal cash flow is θ̃(H) = m + e and θ̃(L) = M. The stock price is P0S (H) = θ̃(H) − P0B (H) = m + e − F and P0S (L) =
θ̃(L) − P0B (L) = M − F. Since security prices reflect all information, the speculator neither trades nor acquires information. Thus, the
cost of capital is zero. Proposition 1 summarizes the above results.
Proposition 1. If the firm has complete information, then:

Table 1
Information structure.
Case Probability Firm’s information Speculator’s information Prices

1 f/2 H ∅ P(H)
2 f/2 L ∅ P(L)
3 1− f ∅ y P(y)

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M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

P0B () = F,
P0S (H) = m + e − F
P0S (L) = M − F,
π = 0,
V0 (H) = m + e,
V0 (L) = M

2.2.2. Equilibrium when the firm has no information

In this case, by acquiring information the speculator has an information advantage over the manager and the market makers. It
should be noted that the speculator always trades stock and risky bond since they are sensitive to information. He never trades riskless
bond since it is information insensitive and the interest rate is zero. More specifically, if F ≤ m − e, the speculator trades only stock. If
F > m − e, he trades both stock and bond.
In order to make money, he must disguise his information from the market makers who try to set efficient security prices given the
aggregate order flows. He buys when he receives good news (y = h), sells when he gets bad news (y = l) To keep his information from
being revealed completely to the market makers, he has to trade as if he were liquidity traders. Thus, his optimal strategy is buy σS (σ B )
shares of stock (risky bond) when y = h and sell σ S (σ B ) shares of stock (risky bond) when y = l . Formally, let di (y), i = B, S, be the
trading strategy of the speculator in market i, then
{
σ i if y = h
di (y) =
− σ i if y = l

Assuming the bond and stock market makers communicate with each other to incorporate all publicly available information into
security prices, then markets are of semi-strong-form efficiency. Let Xi, i = B, S, be the aggregate order flow observed by the market
maker in market i then
Xi = di (y) + ni .

Given the trading strategy of the speculator and the distribution of ni, Xi can take 3 possible values:

• Xi = 2σi when the liquidity trades ni = σ i and y = h.

• Xi = − 2σi when ni = − σ i and y = l.
• Xi = 0 when ni = σi and y = l, or ni = − σ i and y = h .

Thus, the market makers can infer precisely that y = h when they observe an Xi = 2σ i, and y = l when they see an Xi = − 2σi in which case
the speculator’s information is revealed to the markets and he earns zero profit. However, when both XS and XB are zero, the market
makers cannot infer y. As a result, the speculator’s payoff is positive and security prices do not fully reflect y. Note that if the speculator
deviates from this trading strategy, his signal is always revealed to the market makers.
The manager inverts security prices to learn y and uses it to make investment decision. His investment strategy is as follows:

1. if y = h, follow growth strategy.

2. if y = l, follow conservative strategy.
3. If y is not revealed, follow growth strategy since the firm is risk neutral and the expected return of the growth strategy is higher than
that of the conservative strategy.

Proposition 2. If F ≤ m − e the speculator does not trade bond. His optimal information acquisition αm, stock price P0S, bond price P0B, the
cost of capital π, and the value of the firm V0 are given by:

σS e
αm = , (1)
2c

σ2S e2
π= , (2)
8c

3m + M σS e2 σ2S e2
P0S = − F+ − ,
4 8c 8c
P0B = F,

1
V0 = m + [M − (m − αm e) ] − π . (3)
4

Proof. See Appendix. □Proposition 2 indicates that when the firm has no information and chooses riskless debt, capital structure
does not matter although the feedback effect still exists via stock market. Eq. (1) shows that the speculator’s optimal information

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acquisition is positively related to the stock market depth σS and the risk of the growth strategy e but negatively related to the in­
formation cost c. A deeper stock market allows him to trade higher volume to exploit his information to a greater extent and thus get a
high payoff. The riskier growth strategy makes information more valuable given the cost, so the speculator increases its acquisition. As
a result, the cost of capital π (eq. 2), which is the speculator’s payoff from exploiting his information, is also positively related to the
stock market depth and the risk of the growth strategy and negatively related to the information cost c. The value of the firm V0 (Eq.
(3)) consists of three terms. The first term is the value of the firm if there is no feedback effect nor cost of capital. The second term is the
gain from the feedback effect. Recall that with the feedback effect, the manager chooses the conservative strategy if the stock price
indicates that the speculator’s signal is l. Thus, the gain is M − (m − αm e), where αm is the quality of his information. The gain is
multiplied by 14 which is the probability that signal l is revealed. Note that the gain could be negative (or loss) depending on αm. In the
extreme case, αm = 0, it is a loss since M < m by definition. The last term π is the cost of capital which is the discount liquidity traders
require at the time of investing in the firm in anticipation that they might lose to the speculator at a later date.
If the firm chooses risky debt (F > m − e), the speculator trades both stock and bond since both are sensitive to information. The
manager can thus extract information from the prices of both securities. Table 2 presents all eight possibilities. Assuming all variables
are independent, each possibility happens with probability 18. P1i (y) is the price of security i at time 1 when y is revealed to the market
makers and P1i (∅) is the price of security i at time 1 when y is not revealed. We observe that with probability 38, the speculator’s trades
reveal y = h or y = l ; with probability 14, his trades do not reveal his information.

Proposition 3. If F > m − e, the debt is risky and the speculator trades both stock and bond. Furthermore, if the aggregate order flows reveal
the speculator’s information then his payoff is zero and the security prices at time 1 are given by:

1+α 1− α
P1B (y = h) = F + (m − e) ,
2 2
1+α
P1S (y = h) = (m + e − F) ,
2
P1B (y = l) = F,
P1S (y = l) = M − F.

Proof. See Appendix. □

With the feedback effect, the manager extracts information from security prices and uses it to make real investment decisions for
the firm. In doing so, he is able to pursue growth with lower downside risk. A surprising consequence of the feedback effect is that the
bond is riskless when the speculator receives unfavorable news (y = l) but risky when he receives favorable news (y = h),
P1B (y = l) ≥ P1B (y = h). This is because if the manager gets an l signal from the markets, he follows the conservative strategy to avoid
the bad outcome. When he gets an h signal, he engages in the high growth strategy; however, since the signal y might not be perfect,
there is some chance that the investment fails; therefore the bond is risky. In the extreme case, if the speculator gets perfect signal,
α = 1, the bond is always riskless.
For stock, if α is big enough P1S (y = h) > P1S (y = l). Thus, in order to maximize the value of the firm, the manager needs to select
the optimal capital structure which encourages the speculator to get more accurate signal. On one hand, more information helps the
speculator get higher payoff from trades which translates to higher cost of capital since liquidity traders requires a discount in
anticipation that they will lose to informed trades. On the other hand, when the speculator trades on his information, security prices
become more informative which helps the manager make more efficient operation decisions. The optimal capital structure trades off
the two effects.
Proposition 4. If F > m − e and if the aggregate order flows do not reveal the speculator’s information, then the security prices at time 1 and
the cost of capital π are given by:

Table 2
Firm’s investment strategy given security prices.
y dB (y) dS (y) nB nS XB XS Price Firm’s strategy

h σB σS σB σS 2σB 2σS P1i (h) Growth

h σB σS σB − σS 2σB 0 P1i (h) Growth
h σB σS − σB σS 0 2σS P1i (h) Growth
h σB σS − σB − σS 0 0 P1i (∅) Growth
l − σB − σS σB σS 0 0 P1i (∅) Growth
l − σB − σS σB − σS 0 − 2σS P1i (l) Conservative
l − σB − σS − σB σS − 2σB 0 P1i (l) Conservative
l − σB − σS − σB − σS − 2σB − 2σS P1i (l) Conservative

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1
P1B (∅) = (m − e + F),
2
1
P1S (∅) = (m + e − F),
2
α
π(∅) = [(σ S + σ B )e + (σ S − σB )(m − F) ] (4)
2

Proof. See Appendix. □When order flows do not reveal the speculator’s information, the risk-neutral manager selects the growth
strategy since it has higher expected return. Security prices are the average of security values in both states μ̃ = H and μ̃ = L. Note that
if μ̃ = L, the firm goes bankrupt and its stock value is zero. Eq. (4) relates the cost of capital to the quality of the speculator’s infor­
mation α, the risk of the growth strategy e, the market depth σ S + σ B and the capital structure. Other things equal, the cost of capital is

• increasing with the quality α of the speculator’s information. Higher information quality leads to greater speculator’s payoff and
therefore higher cost of capital.
• increasing with the volatility of the growth strategy e. Due to the fact that he is better informed than other market participants,
higher volatility of the growth strategy allows the speculator to exploit his information to a greater extent for profit.
• increasing with the total market depth σ S + σ B. As the speculator must camouflage in liquidity traders to keep his information from
being revealed, deep markets help him trade large volume without being detected, resulting in a higher cost of capital. Note that we
assume σS − σB is positive and unchanged. This is in contrast to the conventional wisdom that deep markets lead to lower cost of
capital.
• decreasing with the level of debt F. This is because equity is more information sensitive than debt. Higher debt leads to lower equity
available to trade in the market which reduces the speculator’s profit. As a result, the cost of capital is lower.

We next derive the optimal information acquisition αm of the speculator when the manager, who has no information about the growth
strategy, chooses risky debt. Propositions 3 and 4 show that the speculator’s payoff5 (or cost of capital) is positive if and only if his
information is not revealed, which happens with probability 14 (see Table 2.) Thus, his expected payoff is 14 π(∅), with π (∅) is given in
Eq. (4). Taking into account the cost of information, the speculator solves the following profit maximizing problem:
1 1
maxα Π(α) = π(∅) − cα2 (5)
4 2

S.t.Π(α) ≥ 0. (6)

Lemma 1. If F > m − e, the profit-maximizing information acquisition αm of the speculator, his profit Π(αm ) and the cost of capital π(αm ) are
given by:

1
αm = [(σ S + σ B )e + (σS − σB )(m − F) ], (7)
8c

1 1
Π(αm ) = cα2m = [(σS + σB )e + (σS − σ B )(m − F) ]2 . (8)
2 128c

1
π(αm ) = cα2m = [(σ S + σ B )e + (σS − σB )(m − F) ]2 . (9)
64c

Proof. See Appendix. □Eq. (7) shows that the speculator’s optimal information acquisition depends on market depths (σS and σ B),
the risk of the growth strategy e and the level of debt F. Other things equal, the speculator increases his information acquisition if

• the cost of the information c is low.

• the markets are more liquid. This is because high liquidity allows him to trade large volume without being detected which results in
higher profit. Furthermore, he acquires more information if the liquidity difference between stock and bond market is larger. This
can be explained by the fact that trading stock is more profitable than bond as stock is more sensitive to information.
• the volatility of the growth strategy increases. Higher volatility allows the speculator to exploit his information advantage to a
greater extent for profit.
• the debt level of the firm decreases. Other things equal, less debt implies more stock available to trade in the market. Thus, the
speculator’s payoff is higher if he has more information. As a result, the manager can use debt as a control variable to affect the
speculator’s information acquisition. When he needs more information for operation decision making, he decreases the level of
debt. This signals to the markets that the firm is risky. The speculator responds to the news by producing more information to trade.

5
We distinguish between payoff and profit. Payoff is the gain from trading securities while profit is the payoff minus the cost of information
acquisition.

8
M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

On one hand, the increase in the speculator’s information acquisition helps the manager make more efficient operation decisions
which result in higher value of the firm. On the other hand, more information acquisition leads to higher cost of capital which
reduces the value of the firm. The manager thus needs to balance the two effects when deciding the capital structure of the firm.

Eqs. (8) and (9) show that at αm both the speculator’s profit Π(αm ) and the cost of capital are increasing in αm but the cost of capital is
twice as much as the speculator’s profit.

3. Optimal capital structure

According to Table 2, with probability 38, the speculator’s signals h or l are revealed and with probability 14 they are not, in which
case the speculator gets positive payoff. Thus, the prices of bond and stock at date 0, P0B and P0S, are given by:
3 3 1
P0B = P1B (h) + P1B (l) + P1B (∅) − πB ,
8 8 4
3 3 1
P0S = P1S (h) + P0S (l) + P0S (∅) − πS ,
8 8 4

where πB and π S are the cost of debt and the cost of equity. Thus, the value of the firm at time 0 is:
V0 = P0B + P0S .

Lemma 2. If F > m − e, the value of the firm depends on its capital structure and is given by:

3
V0 = m + [M − (m − αm e) ] − cα2m , (10)
8

where
1
αm = [(σ S + σ B )e + (σS − σB )(m − F) ]
8c

Proof. See Appendix. □Like the riskless debt case, the value of the firm (Eq. (10)) consists of three terms. The first term, m, is the
value of the firm when the manager has no information and there is no feedback effect nor cost of capital. The second term is the gain
due to the feedback effect which helps the manager avoid the low cash flow in the low state. The last term is the cost of capital. Unlike
the riskless debt case, the amount of information acquired by the speculator αm is a function of the firm’s capital structure. Thus, the
manager can use F as a control variable to maximize the value of the firm by affecting the information acquisition of the speculator.
More specifically, the manager solves the following optimization problem:
{ }
3[ ]
max m + M − (m − αm e) − cα2m
F 8
⎧
⎪
⎪ 1
⎨ αm > [(σS + σB )e + (σS − σB )(m − F) ]
st. 8c
⎪
⎪
⎩
F > m − e.

Proposition 5. The optimal capital structure which maximizes the value of the firm is given by:

3 − 2(σS + σB )
F∗ = m − e. (11)
2(σ S − σ B )

At this capital structure, the speculator’s information acquisition is:

3e
αm (F ∗ ) = . (12)
16c

Proof. See Appendix. □Eq. (11) says that the optimal level of debt F* is a function of the expected return of the growth strategy m,
market depths σ S and σB, and the risk of the growth strategy e. Other things equal,

• If the markets are sufficiently deep (σS + σ B > 3/2), the optimal level of debt is positively related to risk (e). In deep markets, high
risk causes the speculator to produce too much information which can result in too high cost of capital and reduce the firm’s value.
The manager therefore increases leverage to discourage too much information production. However, if the markets are not very
deep (σS + σB < 3/2), high risk alone may not motivate the speculator to produce enough information the firm needs. The manager

9
M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

therefore decreases leverage to encourage more information production. As a result, the optimal level of debt is inversely related to
risk.
• The above effects are amplified further when the stock-bond market difference (σS − σB) increases. Although stock and bond give
the firm the same feedback effect benefits, the stock’s cost of capital is higher than that of the bond because the stock is more
information sensitive. When the stock market is too deep compared to the bond market, the manager increases debt to deter the
speculator from obtaining too much information for trading which could cause excessive cost of capital.
• The debt level is positively correlated with m, the expected return of the risky strategy. Often m is correlated with the firm size. This
implies that large firms tend to use more debt than the smaller ones.

Eq. (12) says that at the optimal capital structure, the amount of information produced by the speculator increases with the risk of the
growth strategy and decreases with the cost of producing information.
Corollary. A sufficient condition for the firm to choose risky debt is

5e2
M >m− .
32c

Proof. See appendix. □Under a feedback effect, M is the cash flow the firm gets when the security prices accurately signal that μ̃ = L.
Thus, the gain from feedback effect is higher if M is larger, other things equal. However, as shown in Lemma 2, in order to control the
informativeness of the security prices, the manager must use risky debt. Large expected gain from the feedback effect provides more
incentive for the firm to employ risky debt.
So far, we have investigated two extreme cases and have shown that if the firm has complete information, the Modigliani-Miller
irrelevance is maintained. However, if it has no information and uses risky debt, there exists an optimal level of debt, given in Eq.
(11), which maximizes the value of the firm. The former is corresponding to probability f = 1 in the information structure in Table 1
while the latter is corresponding to f = 0. For cases in between, 0 < f < 1, the firm has partial information, the optimal debt level is the
expected value of those in the two extreme cases. Since capital structure is irrelevant in the complete information case, the optimal
debt value can vary widely among firms. This could explain a stylized fact, documented by Graham (2000), that firms with similar
fundamental may choose very different capital structures, depending on their information need.
Literature has identified several factors affecting a firm’s capital structure decision, such as taxes, bankruptcy costs, agency costs,
etc. It is unlikely that those factors interact with the informational feedback effect considered in this paper, so feedback effect appears
to be an important factor in a firm’s capital structure decision.

4. Conclusions

This paper develops a game theoretic model of financing with an informational feedback effect to investigate the impact of a firm’s
capital structure policy on the informational efficiency of its security prices. We show that when the firm has complete information or
when information is not critical for its efficient operating decisions, the Modigliani-Miller irrelevance is maintained. The debt is
riskless and the speculator does not acquire information to trade. However, when the firm has incomplete information and information
is imperative to make efficient operating decisions, capital structure does matter and the firm can use it to control the information
production in the market. On one hand, the more information the speculator acquires for trade, the more informative are the security
prices which in turn help the firm make efficient operating decisions. On the other hand, more information acquisition by the spec­
ulator leads to higher cost of capital which decreases the value of the firm. The optimal capital structure trades off the two opposite
effects on the firm. Our results indicate that the speculator’s information acquisition is positively related to the market liquidity but
negatively related to the debt level of the firm. There exists an optimal level of debt which is positively related to the firm size and the
market liquidity but negatively related to the risk of the business.

Appendix A

A.1 Proof of Proposition 2

Proof. If F ≤ m − e, the debt is riskless, P0B = P1B ( ⋅ ) = F and the speculator only trades stock since bond is insensitive to his
information.
With probability 14, the stock aggregate order flow reveals y = h, the manager chooses the growth strategy and the speculator’s
payoff is zero. Thus,

P1S (y = h|G) = (m + e − F)p(μ̃ = H|y = h) + (m − e − F)p(μ̃ = H|y = l)

1+α 1− α
= (m + e − F) + (m − e − F)
2 2
= m + αe − F.

10
M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

P1S (y = l) = M − F.

1
P1S (y = ∅) = [P1S (y = h|G) + P1S (y = l|G) ]
2
PS (y = l|G) = (m + e − F)p(μ̃ = H|y = l) + (m − e − F)p(μ̃ = L|y = l)
= m − F − eα.

⇒ PS (y = ∅) = m − F.

1 σS
π = [PS (y = h|G) − PS (y = ∅) + PS (y = ∅) − PS (y = l|G) ]
2 2
σ S eα
= .
2

σ S eα 1 2
maxα − cα
2 2

The first order condition is:

σS e
− cαm = 0
2
σS e
αm = .
2c

Given the optimal amount of information acquired αm, the speculator’s maximum payoff from his optimal information acquisition is:

σS eαm σ 2S e2
πm = =
2 4c

which is also the cost of capital.

σ2S e2 1 2 σ 2 e2
− cα = S .
4c 2 m 8c

1 1 1
P1S = (m + eαm − F) + (M − F) + (m − F)
4 4 2
3 1 σ S e2
= m+ M− F+ .
4 4 8c

V0 = P1S + P1B − πm

3m + M σS e2 σ2S e2
= + −
4 8c 4c
1
= m + [M − (m − αm e) ] − πm
4

A.2 Proof of Proposition 3

Proof. If aggregate order flows reveal y = h, the manager follows the growth strategy. As a result,

11
M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

P1B (y = h) = F.p(μ̃ = H|y = h) + (m − e)p(μ̃ = L|y = h),

1+α 1− α
= F + (m − e) ,
2 2
P1S (y = h) = (m + e − F)p(μ̃ = H|y = h) + 0p(μ̃ = L|y = h)
1+α
= (m + e − F) .
2

P1B (y = l) = F,
P1S (y = l) = M − F.

A.3 Proof of Proposition 4

Proof. The manager follows the growth strategy when he is uncertain about the signal y of the speculator. Knowing that, the bond
market maker sets the bond price as follows:

1
P2B (∅) = [P2B (y = h|G) + P2B (y = l|G) ],
2

where PB (|G) denotes the bond price conditioned on the manager following the growth strategy.
1+α 1− α
P2B (y = h|G) = F + (m − e) ,
2 2

1− α 1+α
P2B (y = l|G) = F + (m − e) .
2 2

m− e+F
⇒ P2B (∅) = .
2

1
P2S (∅) = [P2S (y = h|G) + P2S (y = l|G) ]
2

Since
1+α
P2S (y = h|G) = (m + e − F)p(μ̃ = H|y = h) + 0.p(μ̃ = L|y = h) = (m + e − F) ,
2

1− α
P2S (y = l|G) = (m + e − F)p(μ̃ = H|y = l) + 0.p(μ̃ = L|y = l) = (m + e − F) .
2

m+e− F
⇒ P2S (∅) = .
2

{ }
1 1 σB
πB (∅) = σB [PB (y = h) − PB (∅) ] + [PB (∅) − PB (y = l|G) ] = [PB (y = h) − PB (y = l|G) ]
2 2 2
[ ]
σB 1+α 1− α 1− α 1+α σB α
⇒ πB (∅) = F + (m − e) − F − (m − e) = [F − (m − e) ]
2 2 2 2 2 2
{ }
1 1 σS
πS (∅) = σ S [PS (y = h) − PS (∅) ] + [PS (∅) − PS (y = l|G) ] = [PS (y = h) − PS (y = l|G) ]
2 2 2
[ ]
σS 1+α 1− α σS α
⇒ πS (∅) = (m + e − F) − (m + e − F) = (m + e − F).
2 2 2 2

α
π(∅) = πB (∅) + πS (∅) = [(σ S + σ B )e + (σS − σB )(m − F) ]
2

12
M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

A.4 Proof of Lemma 1

Proof. From the speculator’s payoff and profit Eqs. (4) and (5):

α
π(∅) = [(σ S + σ B )e + (σ S − σB )(m − F) ], (13)
2

1 1
Π(α) = π(∅) − cα2
4 2
(14)
α 1 2
= [(σS + σB )e + (σS − σB )(m − F) ] − cα .
8 2

The speculator solves the following optimization problem:

maxα Π(α)

The first order condition is:

dΠ 1
= [(σS + σ B )e + (σ S − σ B )(m − F) ] − cα = 0,
dα 8

1
⇒ αm = [(σS + σB )e + (σS − σB )(m − F) ] (15)
8c

The second order condition is:

d2 Π
= − c < 0.
dα2

Substituting αminto (13) and (14), we get:

1
π (αm ) = [(σ S + σ B )e + (σ S − σB )(m − F) ]2 ,
64c
1
Π(αm ) = [(σS + σB )e + (σS − σB )(m − F) ]2 .
128c

A.5 Proof of Lemma 2

Proof. From Propositions 3 and 4, we have:

1 + αm 1 − αm
P1B (h) = F + (m − e) ,
2 2

1 + αm
P1S (h) = (m + e − F) ,
2

P1B (l) = F,

P1S (l) = M − F,

1
P1B (∅) = (m − e + F),
2

1
P1S (∅) = (m + e − F).
2

Therefore,

13
M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

3 3 1
V0 = [P1B (h) + P1S (h) ] + [P1B (l) + P1S (l) ] + [P1B (∅) + P1S (∅) ] − π(αm )
8 8 4
5 3 3
= m + M + αm e − π(αm )
8 8 8
3
= m + [M − (m − αm e) ] − cα2m ,
8
where αm is given by Eq. (15). □

A.6 Proof of Proposition 5

Proof. The firm solves the following optimization problem:

3
maxV0 = m + [M − (m − αm e) ] − cα2m
F 8
1
St. αm = [(σS + σ B )e + (σ S − σ B )(m − F) ]
8c

The first order condition is:

( )(
dV0 dV0 dαm 3 σS − σB )
= = e − 2cα − =0
dF dαm dF 8 8c

3
⇒ αm = e,
16c

1 3e
⇒ [(σ S + σ B )e + (σ S − σ B )(m − F) ] =
8c 16c

3 − 2(σS + σB )
⇒ F∗ = m − e.
2(σ S − σ B )

d 2 V0 (σS − σB )2
2
=− < 0.
dF 32c

Thus, V0 (F ∗ ) is a maximum and

( )
3 3e2 32 e2
V0 (F ∗ ) = m + M− m+ − c 2 2
8 16c 16 c
5m + 3M 9e2
= + 2 .
8 16 c

A.7 Proof of Corollary

Proof. From Proportions 2 and 5:

3m + M σS e2 σ2S e2
V0 (F ≤ m − e) = + −
4 8c 4c
3m + M e2
= + σS (1 − 2σ S )
4 8c
3m + M e2
≤ + 2 .
4 8c

The inequality in the third line is because σ S (1 − 2σS ) achieves the maximum of 18 when σS = 14.

5m + 3M 9e2
V0 (F > m − e) = + 2 .
8 16 c

14
M.T. Vo Journal of Economics and Business xxx (xxxx) xxx

Thus, a sufficient condition for V0 (F > m − e) ≥ V0 (F ≤ m − e) is

5m + 3M 9e2 3m + M e2
+ 2 ≥ + 2
8 16 c 4 8c
5e2
⇒ M ≥m− .
32c

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