Information Quality, Debt Contracting, and Endogenous Project Outcome

• In Event: Analytical models
  In Paper Session: Analytical Models

Abstract

In this paper, we examine the role of information quality in a setting in which a firm needs capital injection from debt market to fund a profitable project. The creditor determines the debt repayment based on a noisy public signal, and the firm can make ex post input to improve the project outcome. We find that higher information quality of the signal decreases the overall efficiency in this setting. A key factor of the negative relationship between information quality and the overall efficiency is that, upon a good signal, higher information quality does not encourage the firm's input much, while upon a bad signal higher information quality significantly discourages the firm's input. This asymmetric impact of information quality on the firm's input incentive upon different signals is driven by the nature of debt contracting: with a debt contract, the creditor cares more about the downside risk than the upside potential of the project outcome. When the information quality becomes higher, the creditor makes asymmetric adjustments in debt terms upon good and bad signals, and therefore impacts the firm's input incentive asymmetrically upon different signals.
In addition, we find that higher information quality has an even more negative effect on the overall efficiency when there is no information asymmetry between the firm and the creditor regarding the state. This is because when the firm itself does not know its state, its input decision merely depends on the realized signal, while in contrast when the firm observes its state, its input decision relies less on the signal.

Authors

• Ming Cherng Deng, Baruch College–CUNY

• Lin Nan, Purdue University

• Xiaoyan Wen, Texas Christian University