Capital Structure Equilibrium under Incomplete Market Conditions

Most discussions of corporate capital structure have been set in the context of a complete capital market. In this paper we study the determinants of capital structure for the incomplete markets case, where incompleteness manifests itself in the form of divergent borrowing and lending rates. We argue that firms have a natural incentive to tailor their financing choices so as to narrow such divergences. While this implies an optimal capital structure for firms in the aggregate, however, competition will drive out profits, and the capital structure of any individual firm may still be a matter of indifference. Firms' incentive to try to complete the market provides a rationale for corporate finance even in a taxless environment. This incentive may also shed light on such related issues as corporate mergers, the use of complex securities and the role of financial intermediaries.