Contents lists available at ScienceDirect North American Journal of Economics and Finance journal homepage: www.elsevier.com/locate/najef Investment decisions and debt financing under information uncertainty Hwa-Sung Kim School of Management, Kyung Hee University, 26 Kyungheedae-ro, Dongdaemun-gu, Seoul 02447, Republic of Korea ARTICLEINFO Keywords: Information uncertainty Information noise Investment decision Debt financing Shareholder-debtholder conflict JEL classification: D81 G31 G32 ABSTRACT This study examines how information uncertainty influences investment decisions. In contrast to prior studies, which assume no information uncertainty, our model includes a discrepancy in valuing debt between shareholders and debtholders at the time of debt issuance. We derive the values of corporate securities and the optimal investment threshold and coupon under in- formation uncertainty. We show that compared with the absence of information uncertainty, debtholders value debt less than shareholders do, and hence, shareholders should contribute more investment funds. Debt financing restraints due to information uncertainty lead to delayed investment. We find that information uncertainty plays a mitigating role in shareholder-debt- holder conflicts over investment policy. Moreover, the information uncertainty costs that shareholders incur increase sharply with the level of information uncertainty. 1. Introduction Several seminal papers show that investment and financing decisions interact. On the one hand, Jensen and Meckling (1976) demonstrate that leverage induces shareholders to choose riskier investments relative to low-risk investments because they benefit from this behavior, referred to as the “asset substitution problem.” This leads to overinvestment, as shareholders are willing to undertake riskier, negative-NPV (net present value) projects. On the other hand, Myers (1977) argues that shareholders prefer to underinvest under a situation in which debtholders receive most of the investment benefits, also known as a “debt overhang pro- blem.” The literature on the interaction between the two decisions postulates that at the time firms undertake an investment, potential debtholders who contribute to funding investments always set the value of debt at the fair market price. 1 This implies that there is no discrepancy between the debt valuations of stockholders and potential debtholders at the time of investment, as in several studies that examine the interaction between investment and financing decisions. The related literature includes Mauer and Sarkar (2005), Sundaresan and Wang (2007), Hackbarth (2009), Pawlina (2010), and Shibata and Nishihara (2012, 2015). However, information uncertainty exists in financial markets due to noise and incomplete information (e.g., Jiang, Lee, & Zhang, 2005; Yu, 2005; Zhang, 2006; Lu, Chen, & Liao, 2010). Zhang (2006) defines information uncertainty as “ambiguity with respect to the implications of new information for a firm’s value, which potentially stems from two sources: the volatility of a firm’s underlying fundamentals and poor information.” In practice, it is very difficult for potential debtholders to accurately estimate the future cash flow from investment due to information uncertainty. As potential debtholders value the debt differently depending on the existence/ https://doi.org/10.1016/j.najef.2019.101106 Received 10 April 2019; Received in revised form 9 September 2019; Accepted 31 October 2019 I would like to thank the anonymous reviewer and Hamid Beladi (the editor) for their valuable and helpful comments. This work was supported by the Ministry of Education of the Republic of Korea and the National Research Foundation of Korea (NRF-2017S1A5A2A01026669). E-mail address: fstar@khu.ac.kr. 1 We consider “potential” debtholders as investors who are about to lend money to a firm for investment, but have not yet purchased the firm’s bonds (e.g., Mauer & Sarkar, 2005). North American Journal of Economics and Finance 52 (2020) 101106 Available online 04 November 2019 1062-9408/ © 2019 Elsevier Inc. All rights reserved. T