Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have

Abstract

Presents a model of the issue-invest decision that occurs in firms when the management of the firm has superior knowledge related to the investment. This decision arises when a firm has a valuable investment opportunity that it wishes to undertake and cannot fully disclose to investors, but must raise the necessary capital through the issuance of common stock. The model demonstrates that firms may rationally choose to forego a valuable investment opportunity if the manner by which the investment would be financed is the issuance of common stock. When debt is added as an option, the model shows that managers will choose debt financing over common stock issuance. Further, if they do have to issue, the managers are shown to prefer bonds over stock. The primary finding of this work is that a firm with insufficient financial slack may not pursue all investment opportunities when there is asymmetric information. Financial slack can be bolstered by restricting dividends or by issuing stock when the information advantage for managers is small. This work lends valuable insight in the evaluation of corporate financing options. (SRD)

Keywords: Debt financing, Stock offerings, Asset management, Investment policies, Information asymmetry, Financial management, Management decisions