Impact of information asymmetry on firms' optimal investment, financing, and payout policies under arbitrary output distributions

We examine the implications of informational asymmetry (IA) on the firm's optimal investment, financing, and payout policies. In contrast to earlier studies, we admit all possible output (cash flow) distributions, thereby expanding the set of firms that can be accommodated within the IA theory. The model is presented in two sections. The first section analyzes the implications of risky debt financing on firms' optimal policies. We show that the firm's optimal behavior is jointly determined by three exogenous factors-the output distributions, the firm's slack, and the nature of the economy (“good,” “average,” “lemons”). We characterize the range of values of the exogenous factors under which: (a) there are no costs (benefits) from external financing under IA, (b) the costs (benefits) are so large that the firm under (over) invests, (c) firms pay risky debt-financed dividends in contravention of the pecking order theory, and (d) lenders earn positive economic profits in competitive markets. We also show that the cost (benefit) of debt financing arising from IA decrease (increase) with increase in the project risk. The second section allows the firm to raise equity in addition to risky debt. In this part we focus on the firm's financing choices and restrict the nature of economy to good. We identify the set of distributions for which IA is costlessly resolved, and show that for all other distributions, higher-valued firms bear a cost. In the latter situation, the firm's external financing choices are in direct contravention of the pecking order theory and our model rationalizes pure equity financing. We provide some linkages between output distributions and firm characteristics, and show that as IA about “downside” cash flow decreases, the firm's propensity to raise external debt increases, implying that high (low) book-to-market firms are more likely to raise debt (equity).