RFS Advance Access originally published online on August 21, 2008
Review of Financial Studies 2009 22(8):3211-3243; doi:10.1093/rfs/hhn076
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Does Asymmetric Information Drive Capital Structure Decisions?
Department of Finance, Ross School of Business, University of Michigan
Department of Finance, Ross School of Business, University of Michigan
Department of Finance, C. T. Bauer School of Business, University of Houston
Send correspondence to either Sreedhar T. Bharath, Department of Finance, Ross School of Business, University of Michigan, Suite E7606, Ann Arbor, MI 48109; telephone: (734) 763-0485; E-mail: sbharath{at}umich.edu; Paolo Pasquariello, Department of Finance, Ross School of Business, University of Michigan, Suite E7602, Ann Arbor, MI 48109; telephone: (734) 764-9286; E-mail: ppasquar{at}bus.umich.edu; or Guojun Wu, Department of Finance, C. T. Bauer School of Business, University of Houston, Suite 220F, Houston, TX 77204; telephone: (713) 743-4813; E-mail: gwu2{at}uh.edu.
JEL Classification: G32
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Abstract |
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Using a novel information asymmetry index based on measures of adverse selection developed by the market microstructure literature, we test whether 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, tangibility, Q ratio, profitability), the sources of firms' financing needs, and such firm attributes as 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 should reasonably be expected of any theory.
We are grateful to Stewart Myers (our NBER discussant), Matt Spiegel (the Editor), and three anonymous referees for their valuable insights. We also thank Viral Acharya, Andres Almazan, Yakov Amihud, Murray Frank, Sudip Gupta, M.P. Narayanan, Norman Schürhoff, Pei Shao, Avanidhar Subrahmanyam, Ramon Uppal, Ivo Welch, and Jaime Zender for useful discussions, and seminar participants at the University of Michigan, Washington University (St. Louis), the 2005 FRA conference, the 2006 NBER Corporate Finance meetings, the 2006 FIRS conference, the 2006 EFA meetings, the 2006 CRSP Forum, the 2006 CAF Winter Research Conference, and the 2008 AFA meetings for comments. Lastly, we thank the Ross School of Business Dean's Research Fund for financial support and Kenneth French and Soren Hvidkjaer for providing financial data.
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