Debt vs. Equity and Asymmetric Information: a Review

Topics: Stock, Stock market, Corporate finance Pages: 55 (16925 words) Published: March 12, 2013

Linda Schmid Klein, University of Connecticut
Thomas J. O’Brien*, University of Connecticut

Stephen R. Peters, University of Cincinnati

March 2002; Forthcoming, The Financial Review

*Corresponding author: Department of Finance, University of Connecticut, 2100 Hillside Rd., Storrs, CT 06269-1041; Phone: (860) 486-3041; Fax: (860) 486-0634; E-mail: Acknowledgements: The authors thank Ivan Brick, Shanta Hegde, Tim Manuel (especially), and Steve Wyatt for reading the paper and for insightful comments.

Abstract: Recent Nobel Prizes to Akerlof, Spence, and Stiglitz motivate this review of basic concepts and empirical evidence on information asymmetry and the choice of debt vs. equity. We first review the literature that holds investment fixed. Then we review capital structure issues related to the adverse investment selection problem of Myers-Majluf. Finally, we discuss the timing hypothesis of capital structure. Empirical studies do not consistently support one theory of capital structure under information asymmetry over the others. Thus, the review suggests that additional theoretical contributions are needed to help understand and explain findings in the empirical literature. Keywords: capital structure, asymmetric information, pecking order hypothesis, timing hypothesis JEL Classifications: G30/G32

Debt vs. Equity and Asymmetric Information: A Review


George Akerlof, Michael Spence, and Joseph Stiglitz received the 2001 Nobel Prize for

introducing an enduring set of tools to examine the economic impact of asymmetric information. The tools have been used to open vast research agendas in many areas of economics, including corporate finance.

In corporate finance, asymmetric information refers to the notion that firm insiders, typically the managers, have better information than do market participants on the value of their firm’s assets and investment opportunities. This asymmetry creates the possibility that the market will not price the firm’s claims correctly, thus providing a positive role for corporate financing decisions.

In this paper we review the impact of asymmetric information on one specific area of corporate finance, the choice of capital structure claims in terms of debt versus equity. As Riley (2001) notes in his general review, capital structure is a topic that has been dramatically affected by the rigorous consideration of information asymmetry. As one part of a comprehensive review of (nontax-driven) capital structure theories, Harris and Raviv (1991) discuss the most important developments in asymmetric information and capital structure, observing that up to that time theoretical research on the topic had reached a point of diminishing returns. However, there has been considerable research in this area since then, especially on the empirical side. We revisit and update the topic in this article. We do not review asymmetric information topics other than


those related to the basic choice between debt and equity, nor do we review capital structure topics other than those related directly to asymmetric information. Our review updates the discussion of the choice of debt versus equity in an asymmetric information environment by using a broad overview of the theory and empirical results. We summarize the theoretical contributions. Our review of the empirical literature is generally limited to a summary of the main results and their interpretations. Rather than attempting to include all the relevant work, we discuss a representative sampling that can provide an understanding of recent developments in this area.

Our review is organized as follows. In Section 2, we summarize the groundwork laid by the 2001 Nobel laureates. In Section 3 we first summarize the Ross (1977) model illustrating how mispriced equity gives managers the incentive to signal the market their private information...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Asymmetric Information. Essay
  • Essay about Debt vs Equity Financing
  • Essay about Debt vs Equity Financing
  • Essay on Debt vs Equity Financing
  • Debt vs Equity Financing Essay
  • Debt and Equity Essay
  • Essay on Equity and debt
  • Information System Review and Report Essay

Become a StudyMode Member

Sign Up - It's Free