Using Project Financing for Mitigating Asymmetric Information Problems

Brennan and Kraus (1987) show that an efficient separating equilibrium in a financing game where the firms have private information about their cash flows does not exist if the cash flows are ordered by the first-order dominance condition. In the present note we relax their assumption about cash flow indivisibility. We show that when the cash flow is divided in parts (projects) and the firms are allowed to issue securities with projects’ cash flows contingent on payoffs, a separating equilibrium may exist even if the firms total cash flows are ordered by the first-order dominance condition.