Optimal Investment and Capital Structure with Stock Market Feedback

This paper studies optimal investment and capital structure policies when firms learn from financial markets. We propose a tractable model of feedback with imperfect information aggregation and allow the firm to choose its capital structure and investment policy in a previous stage. Firms may benefit from committing to time-inconsistent investment strategies that feature more risk taking, which can be implemented by simple managerial compensation schemes. Issuing debt can increase market informativeness and firm value. Under the optimal capital structure, the time inconsistency of investment policies disappears. We derive empirical predictions regarding the relationship between market frictions, managerial compensation and capital structure