Investment Timing and Financing under Asymmetric Information

Abstract:     
This paper develops a real options framework to analyze the effects of asymmetric information on investment and financing decisions when firms require external funds to finance investment. Our analysis shows that corporate insiders can signal their private information to outside investors using the timing of investment and the firm's debt-equity mix. Several important contributions follow from this result. First, we show that firms' equilibrium investment strategies differ significantly from those implied by standard real options models with perfect information. In particular, informational asymmetries erode the option value of waiting to invest and induce firms with good prospects to speed up investment. Second, we demonstrate that informational asymmetries may not translate into a financing hierarchy. Most notably, we provide a rationale for the fact that small, high-growth firms do not behave according to the pecking order theory, and relate the firm's optimal investment and financing strategies to various firm and industry characteristics such as bankruptcy costs, operating leverage, and cash flow volatility.

Keywords: real options, investment timing, asymmetric information, financing

Working Paper Series