Equity finance, adverse selection and product market competition

This paper analyses the effect of asymmetric information between a firm and its outside investors on the firm's competitive position in a model where first-period competition is followed by a financing stage a la Myers and Majluf (1984). In our model, interim profit generated by the competition stage takes the role of financial slack and determines the extent to which external equity finance is required for a new investment opportunity. I consider the full set of equilibria in our version of the Myers and Majluf model and formally analyse financial slack as a comparative statics variable. Using this, I derive the firm's first period objective from first principles. In contrast to models of predatory behavior, I find that in the presence of an adverse selection problem the need to finance externally may provide a strategic benefit rather than a strategic disadvantage. The reason is that the adverse selection problem may induce speculative behavior, which will make the firm more aggressive vis a vis its rival.