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Fully Revealing Equilibria with Suboptimal Investment

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    Abstract

    This paper examines investment and financing policy in "fully revealing" equilibria - equilibria in which information asymmetries are resolved. Since all securities are priced correctly in a fully revealing equilibrium, it seems plausible that such equilibria would be free of the well known Myers-Majluf (1984) problem of inefficient investment. I show to the contrary that, for a large class of problems, whenever there is an equilibrium with efficient investment, there are also infinitely many equilibria in which almost all firms invest inefficiently. These inefficient outcomes survive the standard signaling-game equilibrium refinements. There are also examples that have fully revealing equilibria with inefficient investment but none with efficient investment. These findings contradict the claim of Constantinides and Grundy (1989) that firms invest the socially optimal amount in any fully revealing equilibrium.

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    Paper provided by Ohio State University in its series Research in Financial Economics with number 9507.

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    Handle: RePEc:wop:ohsrfe:9507

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    1. Dybvig, Philip H & Zender, Jaime F, 1991. "Capital Structure and Dividend Irrelevance with Asymmetric Information," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 4(1), pages 201-19.
    2. Cho, In-Koo, 1987. "A Refinement of Sequential Equilibrium," Econometrica, Econometric Society, Econometric Society, vol. 55(6), pages 1367-89, November.
    3. Grossman, Sanford J. & Perry, Motty, 1986. "Perfect sequential equilibrium," Journal of Economic Theory, Elsevier, Elsevier, vol. 39(1), pages 97-119, June.
    4. John, Teresa A & John, Kose, 1993. " Top-Management Compensation and Capital Structure," Journal of Finance, American Finance Association, American Finance Association, vol. 48(3), pages 949-74, July.
    5. Cho, In-Koo & Kreps, David M, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 102(2), pages 179-221, May.
    6. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers, Massachusetts Institute of Technology (MIT), Sloan School of Management 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    7. Brennan, Michael J & Kraus, Alan, 1987. " Efficient Financing under Asymmetric Information," Journal of Finance, American Finance Association, American Finance Association, vol. 42(5), pages 1225-43, December.
    8. Banks, Jeffrey S. & Sobel, Joel., 1985. "Equilibrium Selection in Signaling Games," Working Papers, California Institute of Technology, Division of the Humanities and Social Sciences 565, California Institute of Technology, Division of the Humanities and Social Sciences.
    9. Bhattacharya, Sudipto, 1980. "Nondissipative Signaling Structures and Dividend Policy," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 95(1), pages 1-24, August.
    10. Heinkel, Robert, 1982. " A Theory of Capital Structure Relevance under Imperfect Information," Journal of Finance, American Finance Association, American Finance Association, vol. 37(5), pages 1141-50, December.
    11. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, Elsevier, vol. 13(2), pages 187-221, June.
    12. Persons, John C, 1994. "Renegotiation and the Impossibility of Optimal Investment," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 7(2), pages 419-49.
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