Information Aggregation through Stock Prices and the Cost of Capital

This paper studies a firms optimal capital structure in an environment where the firms stock price serves as a public signal for its default risk. In equilibrium, the number of traders who find it profitable to trade the firms stock increasesas the firm issues more equity. In turn, the precision with which the stock price communicates the firms fundamental to bond investors increases in the number of equity investors. Thus, through its capital structure, firms can internalize the informational externality that stock prices exert on bond yields. Strong firms therefore issue equity to reduce borrowing costs.