A Theory of Capital Structure, Price Impact, and Long-Run Stock Returns under Heterogeneous Beliefs Onur

We analyze a firm’s financing decision in an environment of heterogeneous beliefs and short sales constraints. We study a setting in which the insiders of a firm, owning a certain fraction of its equity, choose between equity, debt, or convertible debt to raise additional financing to implement a positive net present value project. The insiders ’ objective is to maximize their long-run wealth conditional on their own beliefs about their firm’s future prospects. Market participants, each of whom have limited wealth, have heterogeneous beliefs about the firm’s long-run value. We analyze two different economic settings: one in which there are no issue costs or costs of financial distress, and another in which these two costs are significant. We show that, in the absence of these two costs, the average belief of outsiders (“optimism”) and the dispersion in outsider beliefs are the crucial determinants of the firm’s security choice. When outsider beliefs are highly optimistic relative to firm insiders and the dispersion in outsider beliefs is high, the firm issues equity alone; when outsider beliefs are less optimistic (and less dispersed), the firm issues a combination of equity and debt. Neither straight debt alone nor convertible debt alone is optimal in this setting. Once the two costs are significant, we show that the firm issues equity when outsider beliefs are optimistic and highly dispersed; they issue debt when outsider belief