Strategic Financing and Information Revelation Amid Market Competition
48 Pages Posted: 11 Oct 2019
Date Written: June 17, 2019
In practice, interest expense can account for a large proportion of firms' costs, while the interest rate is often influenced by a firm's market prospect. In the presence of information asymmetry, a firm may have an incentive to borrow a larger amount, thereby signaling a high prospect to the lenders. On the other hand, such market confidence, if publicly shown, may stimulate competitors to respond more aggressively, which may incentivize the firm to instead borrow a smaller amount. Motivated by such observations, we investigate the determinants of a firm's financing and information revelation strategy. First, under public financing where the borrowing information is openly accessible, we find that when the firm's internal capital level and the market competition intensity are both low, the firm over-finances, if the market prospect is high, so as to credibly reveal its information to lower the interest rate. On the contrary, when the firm's internal capital level and the competition intensity are both high, the firm under-finances, if the market prospect is low, to credibly signal its information to alleviate competition. In the remaining scenarios, these two opposing incentives are surprisingly neutralized -- the firm neither imitates nor signals -- and the first-best solution is attained. As such, rather counter-intuitively, we show that an increase of the internal capital level can sometimes even be harmful for the firm while benefiting the competitor, and a more competitive market may not always be detrimental. Second, we investigate when the firm may seek private financing so that the borrowing information is not publicly revealed. A classical signaling game arises between the firm and the lender, while the competitor relies on the prior information to make its response. We find that private financing emerges as an equilibrium outcome only when the firm's internal capital level is sufficiently high and the competition intensity is intermediate.
Keywords: OM-finance interface, Game theory, Information revelation
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