I consider a costly-state-verification model where investors observe the realized return with some probability. I interpret a higher probability that the investors are informed as capturing either the transparency of a firm’s business, or the informational efficiency of the market it operates in. The model covers all degrees of informational asymmetries between two extremes: full opacity (Gale and Hellwig (1985)) and perfect information (Modigliani and Miller(1958)). For intermediate degrees of asymmetric information, I find that the optimal capital structure can be implemented by a mixture of debt and equity and, consistently with the evidence, leverage negatively correlates with transparency.
We consider a model of external financing in which entrepreneurs are privately informed about the quality of their projects and seek funds from competitive financiers. The literature restricts attention to monotonic or ‘manipulation proof’ securities and finds that straight debt is the unique optimal contract. We characterize the optimal contract when entrepreneurs can misreport their earnings by some amount. Straight debt is often suboptimal and never uniquely optimal. The optimal contract is non-monotonic and involves profit manipulation in equilibrium. It can be implemented as debt with performance bonuses.