Managerial discretion and debt financing under information uncertainty

Abstract

This study investigates how information uncertainty influences managers' decisions and compensation. It reveals varying financial choices under uncertainty levels. Initially, information uncertainty results in debtholders undervaluing debt in comparison to situations without such uncertainty. Consequently, they consistently estimate a default threshold that is lower than the threshold managers choose to maximize their value. Low uncertainty prompts overinvestment, heightening agency issues. Increased uncertainty leads debt holders to reduce the capital they are willing to lend to companies for investment. To invest early, funds must be injected or costs incurred. Information uncertainty can ease agency conflicts, shifting decisions from overinvestment to underinvestment. Managerial compensation matters: higher fixed salaries curb overinvestment, while increased reservation income exacerbates it.