Debt vs. Equity and Asymmetric Information a Review

DEBT vs. EQUITY AND ASYMMETRIC INFORMATION: A REVIEW 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: thomas.obrien@uconn.edu 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†¦show more content†¦We also review some of the empirical findings related to these models. Section 4 extends the connection between signaling and leverage by examining the pecking order model in Myers and Majluf (1984). They endogenize the firm’s investment decision and demonstrate that managers, acting in shareholders best interests may pass up positive net present value (NPV) investments if the equity necessary to finance them is sufficiently underpriced by the market. We then discuss subsequent theoretical models of firms’ financing and investing decisions, and the implication for the choice between debt and equity. We also review some of the empirical tests related to the pecking order hypothesis. Section 5 reviews the theory and evidence on the timing hypothesis of capital structure choice. Section 6 summar izes and concludes the review. 2 2. Foundations of capital structure and asymmetric information Modigliani and Miller (1958) establish the foundation of capital structure theory and demonstrate that in a world of fully informed investors, no taxes, and risk-free debt, firm value – and in particular, equity value – is determined without regard to the firm’s capital structure. They are rightly credited for this irrelevance result, but the term â€Å"irrelevant† does not appear in the 1958 article in the context of financing decisions. To the contrary, Modigliani and Miller identifyShow MoreRelatedWhy Do Firms Choose Their Capital Structure?1623 Words   |  7 Pages1. Introduction In order to grow, an enterprise needs investments. So they need to start wondering about which securities to acquire and how to finance those investments: with equity, debt or a combination of both (Myers, 2001). The study of capital structure tries to clarify this variety of securities and financing opportunities. In accounting terms, this decision is situated on the right-hand side of the balance sheet (Myers, 2001). In his Capital Structure Puzzle article, Myers (1984) poses theRead MoreMaking Capital Budgeting and Capital Structure Decisions9919 Words   |  40 Pagesattention to academic advice. 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