Essays on Financial Economics
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This dissertation consists of three papers. In the first paper, I study firms' capital raising decisions in a two-stage signaling game. In the model, firms can issue debt or equity to finance sequentially arriving investment projects. Management is assumed to have an initial information advantage over investors. However, when a firm's decision in the first stage can change investors' beliefs and, consequently, impact the security issuance in the second stage, its optimal choice differs significantly from the strict debt-equity preference in a comparable one-stage model. In equilibrium, a dynamic pecking order arises, suggesting that the information friction can solely explain various aspects of observed corporate financing behavior. The second paper is coauthored with Hans Haller. In this paper, we model how different wealth constraints among investors affect an entrepreneur's way of raising capital, his share of project NPV, and his ownership of the new firm. Combining cooperative and noncooperative approaches, we develop and analyze a bargaining framework and demonstrate cases in which a fair division cannot be achieved when sharing of cost and sharing of return are jointly considered. Our results cover conditions on how the entrepreneur can strategically achieve larger net wealth accumulation, and when he can obtain control of the firm. We further discuss the entrepreneur's preferences on the firm's ownership dispersion level under public financing. The third paper argues that although innovation is costlier than imitation, the incumbent firm is endowed with an advantage of enhancing its product ahead of potential competitors. In a model that connects consumers' utility with firms' production, I show that the incumbent's product enhancement decision can foster the creation of a better product, improve consumers' utility, and deter entrance from competitors. The pace of creative activities is determined by the incumbent's potential of improving its product quality and the nature of product differentiation in the industry. Thus, creative destruction may not manifest itself as new firms replacing the incumbent, but as the incumbent constantly renovating its product.
General Audience Abstract
This dissertation consists of three papers. In the first paper I study the adverse selection problem faced by firms in a dynamic information environment, the difference between incentives provided by debt and equity securities, and how different contracts and model settings affect the equilibrium outcome, investment efficiency, and social welfare. The premise of the first paper is that dynamic elements of information asymmetry are key to better understanding how firms raise capital. This study aims to provide a more complete description and improve our understanding of the role of information in capital markets and how asymmetric information might interact with other market frictions. In the second paper I study the origin of the firm and the bargaining problem between entrepreneurs and investors. This second paper intends to provide one possible answer for the question why firms do exist. The main point in the paper is that even when we abstract away from standard frictions like adverse selection or moral hazard, an entrepreneur still has to bargain with investors to raise the required amount of capital. The firm has to be established to enforce the bargaining outcome, which takes the form of an ownership contract, because there is a time gap between conducting the investment and when the proceed can be realized. Another purpose of this second study is to investigate fairness instead of efficiency. Finally, in the third paper, I address the question how and when an incumbent monopolist can deter entry by means of investment in product quality enhancement. In some industries, creative destruction can be frequently observed: Incumbent firms are replaced by new firms that offer slightly different but better products. On the other hand, in a number of industries incumbent firms are at the forefront of innovation and stay ahead of potential entrants. I consider a model that allows for the latter fact combined with another frequent fact: that potential entrants more or less copy the incumbent's prior product, regardless of existence and enforcement of intellectual property rights. This third paper offers predictions on product innovation and market failure across firms and industries.
- Doctoral Dissertations