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Keywords:

  • growth option;
  • investment distortion;
  • information asymmetry;
  • endogenous default
  • C61;
  • D81;
  • G13;
  • G31;
  • G32

Abstract

This paper develops a dynamic model of the financing and operating decisions of firms in the presence of information asymmetry. When the value of growth opportunities is not fully recognized, securities are undervalued, thus influencing the financing and investment decisions. The agency-based underinvestment problem is re-examined under information asymmetry. For firms with greater growth opportunities, the investment distortion resulting from information asymmetry is especially significant. Information asymmetry also increases the expected bankruptcy cost. The cost of information asymmetry in terms of both the firm value and the information spread under the optimal capital structure could be substantial.