Human capital, incomplete information, and capital structure: Theory and evidence

A puzzling issue in the field of capital structure is that the observed debt-equity ratios of many firms are much lower than finance theory would predict. In this paper, we explain this phenomenon in terms of specificity of human capital and contracting incompleteness. In a costly information world, a contract cannot be complete, and therefore managers and investors have not only the incentive but also the ability to engage in opportunistic behaviors. We demonstrate that under these conditions the pattern of observed debt-equity ratios is consistent with the need to resolve the "two-sided" holdup problem embedded in dealings between management and equity owners. The seeming inefficiency of financing practices results from a second-best policy for protecting the interests of investors when information is incomplete. We Apply our theory to explain the capital structure choice by human capital intensive firms. We find strong supporting evidence that there is a negative relationship between the importances of debt in a firm's capital structure and the importance of human capital to its operations.