Capital Structurce, Risk and Asymmetric Information

This paper argues that Myers’ (1984) pecking order hypothesis is a special case that applies when there is no asymmetric information about risk so that there is no adverse selection cost of debt. As soon as outside investors are imperfectly informed about risk, debt can be mispriced and firms may prefer to issue equity. Using a large unbalanced panel of publicly traded US firms, we present evidence i) that there is a general adverse selection logic of capital structure decisions in which firms issue more equity and less debt if risk matters more and ii) that the standard pecking order works well when risk does not matter, irrespective of firms’ age, size, market-to-book ratio, tangibility or the time period. We consider different proxies for asymmetric information about risk, e.g. firms’ recent asset volatilities, the change of implied volatilities obtained from option prices or the impact of credit ratings, and find that our results are robust. Other motives for issuing equity such as debt capacity constraints, market timing or trade-off considerations do not appear to drive our findings.