Information Aggregation Through Stock Prices and the Cost of Capital

Abstract

This paper studies a firm's optimal capital structure in an environment, where the firm's stock price serves as a public signal for its credit worthiness. In equilibrium, equity investors choose whether to acquire information and to trade the firm's equity. This induces a positive relation between the amount of equity issued and the stock price signal's precision. Thus, through its capital structure, the firm can internalize the informational externality that stock prices exert on bond yields. Firms with a strong fundamental therefore issue more equity and less debt than they would if the informational spill-over did not exist.