Capital Structure Choice and the Cost of Enforcing Contracts - Theory and Evidence

Abstract: This paper analyzes the interaction between a firm's optimal capital structure and the type of contracts it uses to deal with its suppliers. We first develop a theoretical model where a firm needs an intermediate good from a supplier, and this intermediate good can be of high or low quality. Court-enforceable contracts can be used to enforce high quality, however their use is costly. If these costs are too high, relational contracts - self-enforcing informal arrangements that can be sustained in long-term relationships - are needed. Relational contracts, though, can only be sustained if debt is not too high. The reason is that a firm's commitment in relational contracts is determined by its future profits in the cooperative relationship, and the need to repay debt reduces future profits. We therefore derive the prediction that higher costs of enforcing formal contracts should be associated with firms having less leverage on average. We test this prediction with the help of two datasets, the Microdatabase Directinvestment (MiDi) provided by Deutsche Bundesbank, which gives balance sheet information on the universe of German foreign affiliates including detailed information on external debt, internal debt and equity capital, and the World Bank's Doing Business Database, which contains information on the average costs of enforcing (formal) contracts between a firm and a supplier of an intermediate good. Using a panel data model for fractional response variables, we can show that an increase in the costs of enforcing contracts in a country makes firms use substantially more equity financing.