Dynamic Information Asymmetry, Financing, and Investment Decisions
Ilya A. Strebulaev
Stanford University - Graduate School of Business; National Bureau of Economic Research
Massachusetts Institute of Technology (MIT) - Sloan School of Management
Stanford Graduate School of Business
January 26, 2014
Rock Center for Corporate Governance at Stanford University Working Paper No. 164
Stanford University Graduate School of Business Research Paper No. 13-12
We reexamine the classic yet static information asymmetry model of Myers and Majluf (1984) in a fully dynamic market. A firm has access to an investment project and can finance it by debt or equity. The market learns the quality of the firm over time by observing cash flows generated by the firm's assets in place. In the dynamic equilibrium, the firm optimally delays investment, but investment eventually takes place. In a "two-threshold" equilibrium, a high-quality firm invests only if the market's belief goes above an optimal upper threshold, while a low-quality firm invests if the market's belief goes above the upper threshold or below a lower threshold. However, a different "four-threshold" equilibrium can emerge if cash flows are sufficiently volatile. Relatively risky growth options are optimally financed with equity, whereas relatively safe projects are financed with debt, in line with stylized facts.
Number of Pages in PDF File: 63
Keywords: dynamic information asymmetry, investment, financing, pecking order
JEL Classification: G31, G32working papers series
Date posted: November 18, 2013 ; Last revised: February 4, 2014
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