Equity Markets and Economic Development: What Do We Know

Z_t represents the degree of information transparency in the equity market. An increase in
(1 - β*), the proportion of type-3 firms who masquerade as type-1 firms, results in lower
values of Z_t , and thus in higher information asymetries. The expected market value of a
risky project can then be defined as:

EMV = zpk₁ + (1 - z )npk₂

n

In equation (3), n =---²— represents the proportion of non-type 1 firms that are type 2. In

n₂ + n₃

the capital market, firms have the choice between two types of contract: a debt contract, in
which repayment d is a lump sum from the proceeds of the project, and a equity contract in
which repayment s is proportional to the net profits from the projects. Under both
arrangements, the lender’s constraint is that the expected income from participation must be at
least equal to pa(α), the amount obtained from storage. Taking this into account, the
shareholder’s expected outcome when financing a risky project is equivalent tors(EMV).
Using the lender’s participation constraint, it follows that equity payments are equivalent to:

₅ = pa (α )
r (EMV )

Assuming Φ to represent output production, the firm’s expected net income from an equity
contract can be given as VE = r(1 - S)pk₁ + Φ . Substituting into (4) yields:

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