Default and liquidation timing under asymmetric information

Abstract

We consider a dynamic model in which shareholders delegate a manager, who observes private information about running and liquidation costs of the firm, to operate the firm. We analytically derive the shareholders' optimal contract contingent on the cost structure of the firm. The information asymmetries change the high-cost firm's default and liquidation timing. Even if the liquidation value is higher than the face value of debt, the shareholders of the high-cost firm, unlike in the symmetric information case, can choose default rather than liquidation in order to reduce the information rent to the manager. The information asymmetries accelerate negative liquidation and delay positive liquidation, while they accelerate default. Although the information asymmetries decrease the equity and firm values, they may increase the debt value. The optimal leverage ratio of the asymmetric information case becomes higher than that of the symmetric information case because more debt mitigates the loss due to the information asymmetries. Our results can potentially account for many empirical findings.

Liquidation, fire sales, and acquirers’ private information

“…Following Mella- Barral and Perraudin (1997), Lambrecht and Myers (2008), Nishihara and Shibata (2017), and Nishihara and Shibata (2018), we consider the following two types of the firm's exit. A successful exit without formal bankruptcy is called sell-out.…”

“…Shareholders receive the residual value (i.e., the sales price minus C/r). For simplicity, as in Lambrecht and Myers (2008), Nishihara and Shibata (2017), and Nishihara and Shibata (2018), we assume no opportunity for debt renegotiation and…”

“…He and Xiong (2012), He and Milbradt (2014), and Chen, Cui, He, and Milbradt (2018) reveal the interactions between debt market liquidity and bankruptcy timing via rollover risks. whereas Lambrecht and Myers (2008) and Nishihara and Shibata (2017) focus on conflicts among managers, shareholders, and debt holders concerning liquidation timing.…”

Signaling game models of equity financing under information asymmetry and finite project life

“…Bouvard (2014) proposes a signaling model to reveal the value of an investment project via sequential investments, thus initiating a learning phase where outside investors can update their beliefs on the probability of holding a high quality project. Besides capital financing, real options signaling game models have been adopted to analyze various corporate finance issues, like liquidation timing of a distressed firm (Nishihara and Shibata, 2017), strategic investment games of incumbent and entrant firms (Watanabe, 2016), decisions on selling out IPO (Nishihara, 2016), mergers and acquisitions strategies of bidder and target firms (Leung and Kwok, 2018). A comprehensive and general review of signaling theory can be found in Connelly et al (2011).…”

Signaling Game Models of Equity Financing Under Information Asymmetry and Finite Project Life

“…Bouvard (2014) proposes a signaling model to reveal the value of an investment project via sequential investments, thus initiating a learning phase where outside investors can update their beliefs on the probability of holding a high quality project. Besides capital financing, real options signaling game models have been adopted to analyze various corporate finance issues, like liquidation timing of a distressed firm (Nishihara and Shibata, 2017), strategic investment games of incumbent and entrant firms (Watanabe, 2016), decisions on selling out IPO (Nishihara, 2016), mergers and acquisitions strategies of bidder and target firms (Leung and Kwok, 2018). A comprehensive and general review of signaling theory can be found in Connelly et al (2011).…”