Default and liquidation timing under asymmetric information

We consider a dynamic model in which shareholders delegate the running of a firm to a manager, who observes private information about the firm's running and liquidation costs. We analytically derive the optimal compensation scheme contingent on the firm's cost structure. Information asymmetries can change the high-cost firm's bankruptcy choice and timing. Most notably, even if the liquidation value is higher than the face value of debt, the high-cost firm can choose default rather than liquidation to reduce the manager's information rent. This can lead to the counterintuitive result that the debt value increases beyond the face value as the firm approaches default, and that it jumps upward at the default time. Information asymmetries accelerate negative liquidation and delay positive liquidation, whereas they accelerate default. The optimal leverage ratio of the asymmetric information case becomes higher than that of the symmetric information case because more debt mitigates the loss due to information asymmetries. Our results can potentially account for many empirical findings.