Capital Financing Under Information Asymmetry: Debt Underpricing as a New Signaling Approach

Abstract

In this study, we develop a static signaling game model to examine the problem of a firm raising funds externally to finance an investment project when there is an information asymmetry between the firm and its outside investors, and the life-span of the investment project is very short. Different from other capital financing models, we also allow the firm to choose the selling price of the securities issued, to explore the possibility of underpricing as a signaling tactic. We provide an efficient procedure for identifying all possible perfect bayesian equilibria (PBEs) resulting in our model, and fully characterize the optimal financing strategy adopted by the firm under various scenarios. Our study finds that when the cost of bankruptcy is low, a high-quality firm cannot signal its type to investors through its choice of financial instrument (equity or debt). The firm must instead sell its debt security at a discounted price (known as debt underpricing) to make the signaling feasible. We also show this signaling strategy to be optimal when the degree of information asymmetry is sufficiently large and the cost of bankruptcy sufficiently low. This corroborates with the empirical studies carried out in previous studies. Our work also reveals that it is still optimal for a firm to issue risky debt even when the information asymmetry cannot be resolved, due to the low information cost embedded in the debt contract. We explore how the debt underpricing improves the investment inefficiency caused by the problem of information asymmetry. We compare different financing strategies in revealing information of a firm, with the aim of determining an optimal strategy.