Separating equilibria, underpricing and security design

Classical security design papers equate competitive capital markets to securities being fairly priced in expectation. We revisit Nachman and Noe's (1994) adverse selection setting, modeling capital market competition as free entry of investors and allowing firms to propose prices for their securities, as happens in private securities placements and bank lending. We identify equilibria in which high types issue underpriced debt, which yields positive expected profits to uninformed lenders, while low types issue steeper securities, such as equity. In addition, pooling equilibria exist in which all firms issue underpriced debt. Introducing pre-existing capital structures provides further foundations for pecking-order theories of external finance.