Review of Quantitative Finance and Accounting, 20: 127–154, 2003
2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Asymmetric Information, Asset Allocation,
and Debt Financing
MICHAEL H. ANDERSON
Assistant Professor of Finance, Charlton College of Business, University of Massachusetts-Dartmouth,
285 Old Westport Road, North Dartmouth, MA 02747, (508) 999-9185
ALEXANDROS P. PREZAS
Associate Professor of Finance, Sawyer School of Management, Suffolk University, 8 Ashburton Place,
Boston, MA 02108, (617) 573-8319
Abstract. We analyze a signaling game where ﬁrms’ ﬁnancing announcements convey private information about
their prospects but a moral hazard problem exists in that managers may suboptimally invest. Consequently, the
attempt to address an asymmetric information problem exacerbates moral hazard. The equilibrium recognizes
both imperfect information problems. Additionally, the ﬁrm must determine how to allocate funds between
two technologies differing in cash ﬂow timing and managerial accessibility. We deﬁne an above-average ﬁrm’s
comparative advantage as that technology which is most dominant relative to a ﬁrm with lesser prospects and show
that the resultant equilibria follow the lines of the ﬁrm’s comparative advantage. Finally, we show that separation
may be achieved costlessly, i.e., with no explicit signaling cost.
Key words: corporate ﬁnance, empire building, game theory, signaling
JEL Classiﬁcation: C72, G31, G32
The existence of agency or moral hazard problems between owners and mangers is well
accepted among both ﬁnancial practitioners and academics.
One particular aspect that has
been examined is managerial empire building (e.g., Grossman and Hart, 1982; Harris and
Raviv, 1990; and Stulz, 1990). That is, a preference for managing the largest organization
possible as compensation, perquisites and prestige tend to increase with the size of the
This issue arises because of managerial access to ﬁrm cash ﬂows and discretion
over investment policy. The use of debt can ameliorate the problem by limiting cash ﬂow
access; however, no single debt level can eliminate it when future cash ﬂows are random.
In particular, given a cash ﬂow realization, if the debt level is set too low then there will