Does Asymmetric Information Drive Capital Structure Decisions?
Sreedhar T. Bharath
Arizona State University - W.P. Carey School of Business
University of Michigan, Stephen M. Ross School of Business
University of Houston; China Academy of Financial Research (CAFR)
September 13, 2006
EFA 2006 Zurich Meetings
AFA 2008 New Orleans Meetings Paper
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.
Number of Pages in PDF File: 55
Keywords: Pecking Order Theory, Capital Structure, Information Asymmetry
JEL Classification: G32,G30,G14
Date posted: March 6, 2006 ; Last revised: December 22, 2016