Book Description

This thesis studies the investment and financing decisions of firms in dynamic markets with asymmetric information. In the first chapter I analyze the effects of time-varying market conditions and endogenous entry on the equilibrium dynamics of markets plagued by adverse selection. I show that variation in gains from trade, stemming from market conditions, creates an option value and distorts liquidity when gains from trade are low. An improvement in market conditions triggers a wave of high-quality deals due to the preceding illiquidity and lack of incentives to signal quality. When gains from trade are high, the market is fully liquid; high prices and no delay in trade attract low-grade assets, and the average quality deteriorates. My analysis also reveals that illiquidity can act as a remedy as well as a cause of inefficiency: partial illiquidity allows for screening of assets and restores efficient entry incentives. I demonstrate model implications using several applications: early stage financing, initial public offerings, and private equity buyouts. Chapter 2, which is a joint work with Ilya Strebulaev and Haoxiang Zhu, reexamines the classic yet static information asymmetry model of Myers and Majluf (1984) in a fully dynamic market. A firm has access to an investment project and can finance it by debt or equity. The market learns the quality of the firm over time by observing cash flows generated by the firm's assets in place. In the dynamic equilibrium, the firm optimally delays investment, but investment eventually takes place. In a ``two-threshold'' equilibrium, a high-quality firm invests only if the market's belief goes above an optimal upper threshold, while a low-quality firm invests if the market's belief goes above the upper threshold or below a lower threshold. However, a different ``four-threshold'' equilibrium can emerge if cash flows are sufficiently volatile. Relatively risky growth options are optimally financed with equity, whereas relatively safe projects are financed with debt, in line with stylized facts. Finally, Chapter 3, which is based on an ongoing work with Ilya Strebulaev and Haoxiang Zhu, extends the analysis of Chapter 2 by allowing cash accumulation within the firm. We consider a firm whose managers possess superior information about the firm's value relative to the rest of the market and analyze the optimal timing of equity issuance. We show that equilibrium features socially inefficient, but privately optimal, delay of investment and equity financing of positive NPV projects. Waiting allows high quality firms to accumulate internal cash and increase investors' beliefs, therefore, reducing the cost of adverse selection. In the dynamic equilibrium low quality firms delay investment as well in hope of being mistaken for the high quality ones. However, when market beliefs are sufficiently low and/or internally accumulated level of cash is sufficiently high the low quality firm prefers to reveal itself.