Signaling Game Models of Equity Financing Under Information Asymmetry and Finite Project Life

Wang, Q. and Kwok, Y. K. (2019). Signaling game models of equity financing under information asymmetry and finite project life. International Journal of Financial Engineering, 6(1), 1950002.

31 Pages Posted: 29 Aug 2018 Last revised: 10 Jan 2022

See all articles by Qiuqi Wang

Qiuqi Wang

University of Waterloo - Department of Statistics and Actuarial Science

Yue Kuen Kwok

Hong Kong University of Science & Technology - Department of Mathematics

Date Written: June 1, 2018

Abstract

We develop the real option signaling games models of equity financing of a risky project under asymmetric information, where the firm quality is known to the firm management but not outside investors. Unlike the usual assumption of perpetuity of investment, we assume that the time window of the investment opportunity has a finite time horizon. The firm chooses the optimal time to issue equity to raise capital for the investment project. The number of shares of equity issued to fund the project depends on the outside investors' belief on the firm quality. The low-type firm has the incentive to sell overpriced securities through mimicking the investment strategy of the high-type firm in terms of investment timing and number of equity shares. On the other hand, the high-type firm may adopt the separating strategy by imposing mimicking costs on the low-type firm. We examine the incentive compatibility constraints faced by the firm under different quality types and discuss characterization of separating and pooling equilibriums. We also explore how the separating and pooling equilibriums evolve over the time span of the investment opportunity. The information costs and abnormal returns exhibit interesting time dependent behaviors, in particular, at time close to expiry of the investment opportunity.

Keywords: Equity Financing, Signaling Games, Separating and Pooling Equilibriums, Real Options

JEL Classification: G31, G32

Suggested Citation

Wang, Qiuqi and Kwok, Yue Kuen, Signaling Game Models of Equity Financing Under Information Asymmetry and Finite Project Life (June 1, 2018). Wang, Q. and Kwok, Y. K. (2019). Signaling game models of equity financing under information asymmetry and finite project life. International Journal of Financial Engineering, 6(1), 1950002., Available at SSRN: https://ssrn.com/abstract=3188645 or http://dx.doi.org/10.2139/ssrn.3188645

Qiuqi Wang

University of Waterloo - Department of Statistics and Actuarial Science ( email )

Waterloo, Ontario N2L 3G1
Canada

Yue Kuen Kwok (Contact Author)

Hong Kong University of Science & Technology - Department of Mathematics ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

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