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Market-Based Solutions to Vital Economic Issues


Kenan Institute 2024 Grand Challenge: Business Resilience
Market-Based Solutions to Vital Economic Issues
Jul 1, 2021

Learning in Financial Markets: Implications for Debt-Equity Conflicts


Financial markets reveal information which firm managers can utilize when making equity value-enhancing investment decisions. However, for firms with risky debt, such investments are not necessarily socially efficient. Despite this friction, we show that learning from prices improves investment efficiency. This effect is asymmetric, however, as investors learn less about projects which decrease the riskiness of cash flows: efficiency is lower for diversifying investments than for focusing (risk-increasing) investments. This also implies that investors’ endogenous learning further attenuates risk-shifting but amplifies debt overhang. Our model provides a novel channel through which learning from financial markets impact agency frictions between stakeholders.

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