Abstract
This paper examines the impact of asymmetric information on firms’ investment and financing decisions when firms issue equity or debt to cover the capital outlay. The study assumes that firm insiders exactly know the firms’ growth prospects, but outside investors do not know. The analysis shows that, under equity or debt financing, there exists a costly signaling equilibrium, in which firm insiders can communicate their private information to outside investors and avoid selling underpriced equity or debt by changing the timing of investment. It is demonstrated that informational asymmetry significantly erodes the option value of waiting to invest and leads firms with good growth prospects to speed up investment. Comparative static analysis shows that the model is consistent with the available empirical evidence. Key words: Adverse selection, asymmetric information, financing decisions, investment timing, signaling equilibrium.
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