Asian Review of Financial Research Vol.21 No.1 pp.33-64
Investment Decisions by Firms with an Option to Wait to Invest in Capital Market Equilibrium under Asymmetric Information
Key Words : Informational Asymmetry,Option to Wait,Investment Efficiency,Capital Market Equilibrium
This paper examines the effects of an option to wait to invest on a firm's financing and investment decisions when capital markets suffer from asymmetric information regarding the profitability of the firm's investment project. We focus on the role of such an option available to the firm as a means to avoid mis-pricing in the spot capital markets. Under symmetric information, financing becomes irrelevant as the firm makes its investment decision efficiently. Here, the option to wait functions only as a means of minimizing its burden of capital cost at the expense of the first mover's advantage. Under asymmetric information, we show that relatively undervalued firms prefer debt financing whereas relatively overvalued ones prefer equity financing. This holds because an undervalued firm can minimize loss from undervaluation by issuing debt whereas an overvalued firm can maximize benefit from overvaluation by issuing equity. As a result, the equity market is always populated by overvalued firms and hence is bound to fail. In equilibrium, therefore, only debt market may open. In equilibrium, firms' behavior goes as follows. A firm with a superior project defers investment in order to avoid mis-pricing applicable in the debt market, anticipating that informational asymmetry will disappear in the next period so that it can finance at a fair market price based on its true profitability. A firm with an inferior project gives up investment because even the maximum payoff from investment is no greater than the debt obligation. All the remaining firms with medium quality projects make investments by raising funds in the debt market.