Optimal leverage and strategic disclosure
Giulio Trigilia∗
November 23, 2015
Abstract
Firms seeking external financing jointly choose what securities to issue, and
the extent of their disclosure commitments. The literature shows that enhanced
disclosure reduces the cost of financing. This paper analyses how disclosure affects
the optimal composition of financing means. It considers a market where firms
compete for external financing under costly-state-verification, but, in contrast to
the standard model, (i) the degree of asymmetric information between firms and
outside investors is variable, and (ii) firms can affect it by committing to a disclosure
policy, possibly at a cost. Two central predictions emerge.
On the positive side, optimal disclosure and leverage are negatively correlated.
Efficient equity financing requires that firms are sufficiently transparent, whereas
debt does not; it solely relies on the threat of bankruptcy and liquidation. Therefore, more transparent firms issue cheaper equity and face a higher opportunity cost
of leveraged external financing. The prediction is shown to be consistent with the
behavior of US corporations since the 1980s.
On the normative side, disclosure externalities lead to under-disclosure and excessive leverage relative to the constrained best. When feasible, mandatory disclosures are Pareto improving. If ‘mandating transparency through disclosure’
proves infeasible, the mapping I derive from greater equity financing to endogenously higher transparency suggests that regulators should tighten the capital requirements. Capital standards are especially useful when (i) firm performances are
highly correlated, and (ii) disclosure requirements can be easily dodged – conditions
that seem to apply to large financial firms.
Key words: leverage, costly-state-verification, disclosure, asymmetric information, capital requirements, financial regulation, optimal contracting
JEL classification: D82, G21, G32, G38
∗
University of Warwick, Department of Economics. Email: g.trigilia@warwick.ac.uk