Preserving "Debt Capacity" or "Equity Capacity": A Dynamic Theory of Security Design under Asymmetric Information

In a dynamic model of optimal security design, we show when firms should preserve "equity capacity" through choosing high target leverage or "debt capacity" through choosing low target leverage. Thereby, firms reduce a problem of underinvestment or overinvestment when they must raise future financing under asymmetric information. Which problem arises depends on whether additional financing is raised at competitive terms or whether there is a lock-in with initial investors. Firms’ initial (or target) capital structure matters as it affects the "outside option" of both insiders and outside investors. Our theory also entails implications for start-up and venture capital financing.