Information production, dilution costs, and optimal security design

We investigate the problem of a firm wishing to finance a project by issuin g securities under asymmetric information. We find that, when outside inves tors can produce (noisy) information on the firm's quality, the degree of i nformation asymmetry resulting in equilibrium is endogenous and depends on the information sensitivity of the security issued. Thus, in contrast to th e prediction of the pecking order theory (see, e.g. Myers and Majluf, J. Fi nancial Econom. 13 (1984) 187-221) a security with low sensitivity to priva te information, such as debt, does not always dominate one with high inform ation sensitivity, such as equity. A firm's preference for equity rather th an debt depends on the costs of information production, the precision of th e information-production technology, and the extent of the information asym metry. We also study the optimal security design problem and find that, dep ending on the cost and precision of the information-production technology, risky debt or a composite security with a convex payoff emerges as optimal securities. (C) 2001 Elsevier Science S.A. All rights reserved.