Project financing, entrepreneurial activity, and investment in the presence of asymmetric information

We analyze a two-period signaling model in which a representative entrepreneur in a regional economy has a project that generates a random cash flow and that requires investment that the entrepreneur raises from a competitive market. The project's type is known to the entrepreneur but not to the investors. Further, the entrepreneur is restricted to issuing debt only or equity only. We first show that there is no separating perfect Bayesian equilibrium (PBE) contract involving the issuance of equity only, that there exists a pooling PBE contract involving the issuance of equity only, and that a debt contract is preferred to an equity contract by our entrepreneur. Next, we suppose that the entrepreneur incurs a non-pecuniary cost of financial distress F > 0 whenever he is unable to make a repayment at time t = 1. We provide conditions on F under which a pooling PBE contract with debt exists and a separating PBE contract with debt and equity exists. Finally, we examine whether a high type entrepreneur will prefer a setting with a cost of financial distress (F > 0) or a setting in which there is no such cost (F = 0).