Capital Structure Choice Under Asymmetric Information and Overconfident Managers

Abstract

Traditional pecking-order theory (POT) cannot explain why good-quality firms issue equity: this is often considered to be an empirical puzzle. We build a model of capital structure that has elements of both asymmetric information and behavioral finance. Firms have private information about their expected performance. The model also includes overconfident managers. Our model predicts that high-quality firms may issue equity in equilibrium, which contrasts the results in Fairchild (2005). Unlike in Fairchild (2005), managers are not equally overconfident and no exogenously given bankruptcy costs exist in our model. We test our model using a large set of data from the U.S. market and find strong empirical support.

Keywords: asymmetric information; signalling with capital structure; overconfident managers; capital structure and operating performance; pecking-order theory; behavioral finance

JEL Classification: D82, D92, G02, G24, G32