This paper examines how the entrepreneur makes an optimal choice of capital structure under
various assumptions on risk attitude and tax systems. Under a tax system putting equity at a
disadvantage, it is demonstrated that if the preferential treatment of tax for debt is not so great,
then the risk-averse entrepreneur who is borrowing from risk-neutral investors opts for a capital
structure which includes both debt and equity. This result is shown to remain true in contracts
with a single risk-averse investor. The reason is that the entrepreneur, being a risk-averse residual
claimant, is willing to smooth consumption at the cost of tax. The risk-neutral entrepreneur chooses
pure debt. With equity at a tax advantage, the risk-averse entrepreneur chooses pure equity. This
paper also considers asymmetric information. The following results are established for the risk-averse
entrepreneur and risk-neutral investors. In the separating equilibrium, if equity is at a tax disadvantage,
then the more able entrepreneur selects a higher debt-equity ratio; if equity is tax-favored, then
the more able entrepreneur offers outside equity holders a smoother (contingent) repayment schedule.
This reflects the fact that by bearing more loss of consumption smoothing, the more able entrepreneur
can separate himself from the less able entrepreneur. In the pooling equilibrium, the above results
obtain for the less able entrepreneur. In general, hence, the repayment schedule becomes smoother
in some sense under asymmetric information.
Keywords：Capital Structure, Consumption Smoothing, Risk-Aversion, Asymmetric Information,
Separating Equilibrium, Pooling Equilibrium