Default and liquidation timing under asymmetric information

We consider a dynamic model in which shareholders delegate a manager, who observes private information about running and liquidation costs of the firm, to operate the firm. We analytically derive the shareholders’ optimal contract contingent on the cost structure of the firm. The information asymmetries change the high-cost firm’s default and liquidation timing. Even if the liquidation value is higher than the face value of debt, the shareholders of the high-cost firm, unlike in the symmetric information case, can choose default rather than liquidation in order to reduce the information rent to the manager. The information asymmetries accelerate negative liquidation and delay positive liquidation, while they accelerate default. Although the information asymmetries decrease the equity and firm values, they may increase the debt value. 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 the information asymmetries. Our results can potentially account for many empirical findings. JEL Classifications Code: D82; G31; G33.