Information asymmetry and the commitment role of debt financing

Purpose We show that debt financing can increase firm value by serving as a commitment device in the presence of information asymmetry. Design/methodology/approach We develop a model in which firms privately learn the true quality of their investment projects over time, which can cause adverse selection when these firms seek to raise additional capital for new investments in later stages. Using this framework, we investigate the optimal capital structure of firms that can mitigate the adverse selection that is expected to arise in the future. Findings We find that each firm’s owner may choose to issue debt ex ante to avoid the adverse selection in the future because the intentionally created debt burden will hurt firms with low-quality investment projects more severely, discouraging these firms from mimicking high-quality firms to raise additional capital for new investments. Our model also predicts that equity or enterprise values of firms in the industry with higher leverages will diverge more significantly over time. Originality/value Our paper contributes to the capital structure literature by providing a novel mechanism to show that debt financing can improve firm value by acting as a commitment device in the presence of information asymmetry.