Real options : duopolistic competition under asymmetric information

Abstract

The real options approach to investment decisions has gained widespread popularity over the past decades for the ability to highlight the value of flexibility under uncertainty. Theory has been evolving rapidly, much of which has been concerned with increasing realism through incorporating characteristics of various real-world scenarios. This thesis seeks to contribute to this literature by studying exercise of real options when both asymmetric information and duopolistic competition are important factors to consider. Specifically, the aim is to compare exercise of real options in a duopoly with and without the need for external financing under asymmetric information. Two different models are developed, building on existing models on asymmetric information and duopolistic competition. Firms are assumed to have different growth prospects, and require external finance from uninformed outsiders to be able to invest. Equilibrium outcomes show that external financing under asymmetric information affect the trigger level for a good type of firm, but that the direction of distortion is unclear. When outsiders can deduce the type of follower, the trigger level of a good firm will always drop, while in the opposite case this is not necessarily true. Furthermore, the analysis shows that when outsiders are able to deduce the type of follower, good firms may actually choose to invest reactively in order to avoid underpricing. Finally, both models predict that the need for external finance under asymmetric information will erode the value of old shareholders in a good type of firm, either through distorted timing or underpricing arising from adverse selection. Old shareholders of bad firms are contrarily indifferent at worst, and may for some initial values be better under asymmetric information.