Corporate Policies In A World With Information Asymmetry

A corporate manager typically oversees several ongoing projects and has the opportunity to invest in new projects that add wealth to the stockholders. Such new projects include expanding the corporation's existing business, entering into a new line of business, acquiring another business, and so on. If the firm does not have sufficient internal capital (cash) to finance the initial investment, the manager must enter into a transaction with outside investors to raise additional funds.

In this situation, the manager of a public corporation faces two key decisions:

• Should he transact with outside investors and raise the necessary capital to invest in the project? The answer to this question determines the firm's investment policy.
• If the manager decides to raise external capital how should the investment be financed — with debt, with equity, or with some other security? The answer determines the firm's financing policy.

Modern corporate finance theory, originating with the seminal work of Merton Miller and Franco Modigliani, has demonstrated that these decisions depend on the information that the manager and investors have about the firm's future cash flows.

In this book, the authors examine these decisions by assuming that the manager has private information about the firm's future cash flows. They provide a unified framework that yields new theoretical insights and explains many empirical anomalies documented in the literature.