In this model, firms find high level of debt attractive if the share of cost reimbursed is high enough to compensate for the higher probability of bankruptcy. As the cost of debt increases, the threshold of cost reimbursement for which this holds goes up and as a result firms operating under high-powered regulation make proportionally larger reductions in leverage.

To test these predictions we have created an original panel dataset of 124 transport concessions in Brazil, Chile, Colombia and Peru covering the period 1992-2011. Regulatory information is sourced from project contracts, sector legislation and renegotiation agreements (which we have for every project). Financial data is sourced directly from regulatory agencies and from commercial databases.

To capture the power of the regulation we include a dummy equal to 1 if the firm is regulated by price cap. It has previously been claimed however that the high incidence of renegotiation in Latin America leads to a convergence of regulatory regimes (e.g. Sirtaine et al 2004). For our purposes, if firms can renegotiate whenever they are in financial difficulty, then the incentive to use leverage will not vary across different types of regulation. That is, even under high-powered regulation firms can increase prices by using high leverage. By examining contract renegotiations, we show that this is not the case: being in financial difficulty is not a significant determinant of renegotiation.

To investigate the effect of regulatory design on leverage, we begin by running pooled OLS regressions. We find that the price cap dummy is positive but insignificant. To deal with the likely endogeneity of regulation, we next analyse how leverage responds _within_ projects to changes in the cost of debt. As predicted by the model, we find that price cap firms make proportionally larger reductions in leverage when the cost of debt increases.

Our empirical work has implications for other capital structure theories. In particular, we find little evidence to support the trade-off view widely held in the infrastructure literature: return on assets (ROA) is negatively correlated with leverage and firms significantly reduce leverage as stock markets become more developed. Overall, our control variables are broadly consistent with findings from listed firms both in developed (Frank & Goyal 2009, Rajan & Zingales 1995) and developing (Booth et al 2001) countries.

# **2. Theory**

The objective of the model is to provide comparative statics regarding the effect of price regulation incentives on the capital structure of the regulated firm. We start by doing so in the simplest possible model, which describes the debt-issuing decision of a firm reacting to a pre-announced price setting rule, in a framework inspired by Spiegel and Spulber (1994) and Cambini and Spiegel (2011). We first highlight our main point in the absence of either moral hazard or strategic considerations such as renegotiation of the price setting rule. We then sketch how our results extend under these considerations.

Our principal divergence from Spiegel and Spulber (1994) and Cambini and Spiegel (2011) is in the formulation of the price setting mechanism. Both of the above papers assume that the regulator maximizes the Nash product of firm profits and consumer surplus. This is justified on the basis that “in practice, because negotiations take place between the firm, consumers, and the regulator concerning each step in the calculation, regulators can exercise considerable discretion in the rate-setting process” (Spiegel 4