Equity-based finance for firms

Credit is a vital source of investment financing in most economies. Debt-based contracts allow cash-constrained firms to borrow against future profits without ceding control of their firm, using a relatively simple fixed repayment structure. However, excessive debt can lead to more fragile firms, and a misallocation of investment. While the optimal capital structure for a typical firm is likely to contain a combination of both debt and equity, most tax systems systematically discriminate against equity financing by subsidising debt. In Chapter 1, I investigate the effect of a policy change in Belgium that mitigated the classical tax discrimination between debt and equity financing through allowing firms to reduce their taxable income by an amount based on the equity in their capital structure. I find that this policy led to significantly lower leverage ratios, with the effect being greater for larger firms, as would have been expected given the relative incentives for large firms created by the policy change. Analysis of heterogeneous effects reveals that the decrease in leverage was most significant for those firms who were most exposed to risk in the pre-policy period, which provides favourable evidence for the effect of such policies on reducing leverage.
The predominance of debt-based financing is also evident in developing countries, which may benefit from a greater availability of equity-based financing products. In Chapter 2, I present results from work with two of the largest microfinance institutions in Pakistan to investigate the effects of ‘microequity’ contracts on microenterprises. I implement an artefactual field experiment with Pakistani microenterprise owners, designed using a simple model of investment choice. Results reveal that equity-financed microenterprise owners chose investment options with a greater expected profit than those under debt financing, with heterogeneity analysis suggesting a larger effect for more risk-averse individuals. In the second part of Chapter 2, I present results from a field survey that provides insights on the reasons for which most microfinance institutions do not actually offer microequity products, despite their potential benefits. Results indicate the practical implementation challenges related to costly state verification, adverse selection into income-sharing contracts and moral hazard caused by inappropriatelytailored profit-sharing ratios. Chapter 3 investigates the demand for a shared-ownership microfinance contract, using a field experiment with the same participants as Chapter 2. The contract is designed to help growth-oriented microenterprise owners who have reached their borrowing limit to expand their business with the purchase of a fixed asset. High take-up was observed for the shared-ownership product in general, with a strong preference for a more flexible repayment schedule, which was randomly offered to half of the treatment group. Analysis of heterogenous demand provides some evidence that the preference for flexible contracts is particularly strong among the most risk-averse microenterprise owners, who may benefit more from the implicit insurance inherent in shared-ownership contracts.

Keywords: Small firms in developing countries
Development economics
Debt and equity finance policy
Microequity
Microenterprises
Corporate finance
Microfinance
Microcredit
Self-employment
Advisor: Quinn, S
Mayer, C