Debt vs. Equity and Asymmetric Information: a Review

16933 Words Mar 21st, 2013 68 Pages
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
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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 summarizes and concludes the review.

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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 “irrelevant” does not appear in the
1958 article in the context of financing decisions. To the contrary, Modigliani and Miller identify
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