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Does Asymmetric Information Drive Capital Structure Decisions?

55 Pages Posted: 6 Mar 2006 Last revised: 22 Dec 2016

Sreedhar T. Bharath

Arizona State University - W.P. Carey School of Business

Paolo Pasquariello

University of Michigan, Stephen M. Ross School of Business

Guojun Wu

University of Houston; China Academy of Financial Research (CAFR)

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Date Written: September 13, 2006

Abstract

Using a novel information asymmetry index based on measures of adverse selection developed by the market microstructure literature, we test if information asymmetry is an important determinant of capital structure decisions, as suggested by the pecking order theory. Our index relies exclusively on measures of the market's assessment of adverse selection risk rather than on ex ante firm characteristics. We find that information asymmetry does affect the capital structure decisions of U.S. firms over the sample period 1973-2002. Our findings are robust to controlling for conventional leverage factors (size, Q ratio, tangibility, profitability) and several firm attributes, such as funding needs, sales growth, real investment, stock return volatility, stock turnover, and intensity of insider trading. For example, we estimate that on average, for every dollar of financing deficit to cover, firms in the highest adverse selection decile issue 30 cents of debt more than firms in the lowest decile. Overall, this evidence explains why the pecking order theory is only partially successful in explaining all of firms' capital structure decisions. It also suggests that the theory finds support when its basic assumptions hold in the data, as it should reasonably be expected of any theory.

Keywords: Pecking Order Theory, Capital Structure, Information Asymmetry

JEL Classification: G32,G30,G14

Suggested Citation

Bharath, Sreedhar T. and Pasquariello, Paolo and Wu, Guojun, Does Asymmetric Information Drive Capital Structure Decisions? (September 13, 2006). EFA 2006 Zurich Meetings; AFA 2008 New Orleans Meetings Paper. Available at SSRN: https://ssrn.com/abstract=789725 or http://dx.doi.org/10.2139/ssrn.789725

Sreedhar Bharath (Contact Author)

Arizona State University - W.P. Carey School of Business ( email )

400 E. Lemon Street
Tempe, AZ 85287
United States
347-256-8784 (Phone)

Paolo Pasquariello

University of Michigan, Stephen M. Ross School of Business ( email )

709 Tappan Street
Room R4434
Ann Arbor, MI 48109
United States
734-764-9286 (Phone)
240-526-7168 (Fax)

HOME PAGE: http://webuser.bus.umich.edu/ppasquar/

Guojun Wu

University of Houston ( email )

220F Melcher Hall
Houston, TX 77204-6021
United States
713-743-4813 (Phone)
713-743-4789 (Fax)

HOME PAGE: http://www.bauer.uh.edu/wu

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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