Dynamic optimal investment policy under incomplete information

Abstract

This paper extends the classic dynamic corporate finance theory by incorporating incomplete information, where the return on a productivity shock is unobservable but known to be either high or low. An investor could dynamically update his/her belief about the expected return by following the history of realized productivity shocks. This paper predicts that incomplete information has first-order effects on valuation, i.e., the average q and marginal q, in addition to the firm’s decisions, i.e., payout, investment and liquidity management. Specifically, with an optimistic belief about the expected return, involving a higher firm value, the investor prefers delaying payout to hold more cash for future investment. In contrast, a pessimistic belief will induce the investor to adopt a conservative/flat investment decision, which reflects a weaker liquidity management motivation.