Information Asymmetry, Corporate Debt Financing and Optimal Investment Decisions: A Reduced Form Approach

Under the assumption of information asymmetry between market investors and firm managers, a reduced form model of a firm is developed in order to derive optimal investment strategies and capital structures while taking into account the effects of dividend policies and taxes. The motivation of the reduced form approach lies in its empirical implementation tractability. Closed-form solutions for debt issuance prices and debt values from firm managers’ perspective are derived. Considering the inconsistency between the two prices incurred from the asymmetric information, a firm’s problem of optimal investment risk determination is presented and solved by trading off two opposing effects: asset substitution and default cost. Furthermore, the optimal dividend policy and tax benefits from debt interest payment are also considered, and the application of the model in portfolio management is discussed. Finally, two simple examples are provided. Under these two specific settings, the optimal investment policies are derived explicitly to illustrate the implementation of the model proposed in this paper and demonstrate the general consistency of the results implied by our methodology and the traditional structural framework.