Information Quality, Debt Contracting, and Endogenous Project Outcome

Abstract

In this paper, we examine the role of information quality in a setting in which a firm needs capital injection from a perfectly-competitive debt market to fund a profitable project. A representative creditor determines the debt repayment based on a noisy public signal about the project's state to break even, and the firm can make ex-post input to improve the project outcome. We find that higher information quality of the signal discourages the firm's input and thus decreases the overall efficiency. This result is mainly driven by the nature of debt contracting: the creditor cares more about the downside risk than the upside potential of the project outcome. When the information quality becomes higher, the creditor makes asymmetric adjustments in debt terms upon good and bad signals, thereby impacting the firm's input decisions asymmetrically upon different signals. Specifically, upon a bad signal, higher information quality significantly increases the debt repayment and thus discourages the firm's input, whereas upon a good signal, higher information quality does not reduce the debt repayment much and can barely encourage the firm's input. In addition, we find that this negative effect of higher information quality is even more pronounced when there is no information asymmetry between the firm and the creditor. This is because when the firm itself does not know its state, its input decision merely depends on the signal, whereas when the firm observes its state, its input decision relies less on the signal.